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Fiscal Federalism After the California Taxpayers' Revolt: A Sorting Out of Sorts John Shannon Since the 1978 California taxpayers' revolt, we have witnessed a dramatic change in intergovernmental fiscal behavior--spending acceleration at the federal level and deceleration at the state-local level (see Figure 3-1). This paper addresses three questions raised by this significant divergence in spending patterns: 1. What caused this growing divergence? 2. Are the trends likely to continue? 3. How will fiscal trends reshape federal and state-local relationships? THE GREAT STATE-LOCAL SLOWDOWN What caused the great slowdown in state-local outlays after 1978? Fiscal restraint was dictated by the three Rs: revolt of the taxpayers, reduced federal aid flows, and the recession. These three fiscal shocks came in fairly rapid succession. For the first time since World War II it was easier for most state and local officials to say ~no. rather than ~yes. to requests for spending increases. Revolt of the Taxpayers (1978-1980) The taxpayers' revolt not only imposed many tax and expenditure limitations, it also sent a powerful message to state and local policymakers, most of whom escaped highly restrictive fiscal limitations. (For a detailed, state-by-state description of tax and expenditure lids see USACIR, 1984:98-99.) The message was clear: If you 71

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73 want to avoid Proposition 13-type restrictions, make sure that the increase in public spending does not exceed the growth of the private economy. The fiscal braking effect of the tax revolt is clear- ly evident when state-local expenditure behavior is ana- lyzed on a before and after basis. During the long, and for the most part affluent, period that started with the end of the Korean War and ended with Proposition 13, state and local spenders chalked up a hefty 4.5 percent average annual increase in per capita expenditures (when ~ ~ ~~ Between 1978 and 1983, real _ Although a few energy-rich states, e.g., Alaska and Wyoming, still kept their foot on the accelerator, most of the 50 state- local systems applied the expenditure brakes. The same braking effect has been evident on the state-loca~ employment front. In the pre-Proposition 13 era, states and localities averaged about a 3 percent annual increase in public employment, adjusted for popu- lation. After the tax revolt (1978-1983), state and local governments reversed that trend, annually decreas- ing employment by about 1 percent. adjusted for inflation). expenditures actually decreased 1 percent. Reductions in Federal Aid Flows--1979-1984 Almost immediately after the taxpayers' revolt in California, state and local authorities received a second major jolt. Federal aid programs, the fastest growing items in state-local budgets prior to 1978, became a drag on federal revenues. Federal aid to states and localities began to decline during the second half of the Carter administration due both to the end of the countercycIical aid programs and . . . to the growing federal budget squeeze. - _ ~ , _ _ , This squeeze on federal aid was greatly intensified in 1981 when Congress approved the Reagan administration's plan to raise de- fense outlays sharply while simultaneously granting major tax cuts. Fearful that the resultant increase in the deficit would once again release strong inflationary forces, Congress had no alternative but to trim low- priority budget items in general and federal aid pro- grams in particular (see Figure 3-2). Real (adjusted for inflation) reductions in federal aid flows have not been offset by equivalent increases

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16- 14- 10- 8- 6- 4- 2- O- 1953 58 63 68 Calendar Years 74 Percent 26- 24- 22- 20- 18- _ _ /1~ / Federal Aid as % of State-Local Budnet' 7 73 78 80 83e : :' federal Aid as % of Federal Budget2 1 1 1 1 e--estimated. [Federal aid as a percentage of state-local expendi- tures after transfers. 2Federal aid as a percentage of federal expenditures from own funds. SOURCE: USACIR staff compilation based on survey of Current Business. FIGURE 3-2 The rise and decline of federal aid. in state and local fiscal expenditures. In the past, the proliferation of federal categorical aid programs with ~matching. provisions whetted state-local tastes for various public goods and services and accelerated state-local tax efforts. In the post-Proposition 13 era, federal aid cutbacks and capped block grants combined to have the opposite effect--the demand for

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75 public sector goods was dampened and a powerful external pressure for higher state and local taxes was thereby removed. Although there was definitely some easing of the fiscal squeeze in fiscal years 1983 and 1984, in all likelihood the pressure to cut back on federal aid flows will become very strong in the wake of the November 1984 election. Recession--No Bailout Just when it appeared that states and localities had taken their worst lumps at the hands of the tax re- volters and federal aid cutters, they received their third big jolt--the major recession that began in 1981. That recession will be seared into the memory of state and local officials because of its severity, its large revenue shortfalls, and its Fend for yourself. inter- governmental scenario. The Fend for yourself. feature was especially note- worthy because it represented a sharp departure from earlier intergovernmental experience. Over the years, state and local authorities have become accustomed to having the federal cavalry--albeit somewhat belatedly-- come charging over the hill to break the recessionary siege with aid from Washington. Many officials keenly remember the Economic Stimulus Program of la77-1978, when the federal government authorized $16 billion in antirecession grants to states and local governments. This time, however, no federal aid was authorized and state and local policymakers were confronted only with far more painful alternatives--program cutbacks or sharp tax hikes, or both. THE GREAT SPEEDUP IN FEDERAL EXPENDITURES While state-local expenditures began their downward path after the passage of Proposition 13, federal expen- ditures turned sharply upward, rising in constant dol- lars from $1,146 per capita in 1978 to an estimated $1,475 in 1983, an increase of 29 percent. The increase in federal spending is attributable to the three Ads.: deficit financing, defense, and demographics (shorthand for the heightened demand for social security and Medi- care benefits).

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76 Deficit Financing Just as the tax revolt sharply influenced the behavior of state and local officials, deficit financing goes a long way in explaining why federal spending continued to rise in the post-Proposition 13 era. Unlike state and local officials disciplined by balanced budget require- ments, federal policymakers could finesse revenue short- falls through the simple expedient of borrowing money. Thus, deficit financing enabled federal officials to avoid making the painful choice of cutting federal expenditures or raising taxes, or both. If political realities make it hard to balance the budget in good times, acceptance of the Keynesian countercyclical doctrine has made it downright un-Amer- ican to balance the budget in bad times. Conservative political leaders strongly object to major tax increases during a recession on the grounds that it is bad eco- nomic policy. By the same token, liberal political leaders oppose major cuts in domestic programs as being both inhumane and withdrawing a necessary stimulus to economic recovery. Although deficit financing has rendered yeoman ser- vice on the revenue side of the budget by papering over tax shortfalls, it has become a very expensive item on the expenditure side of the federal budget. AS seen in Figure 3-3, after adjusting for inflation, the per capita outlay in constant dollars for interest payments on the public debt has shot up from $72 in 1969 to an estimated $190 for the 1983 calendar year. This significant in- crease in interest costs is due both to high interest rates and to the rapid growth in the size of the accumu- lated federal debt, which recently crossed the $1.5 trillion mark. Defense and Demographics The next two ~Ds.--defense and demographics--stand out as driving forces accelerating federal spending at an unprecedented peacetime rate. Without strong braking action, federal expenditures will continue to rise, probably at an even faster rate than between 1978 and 1982. Demographics are now working against the national government because it has assumed primary responsibility for income support and medical care of an aging popula-

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77 u, cr an 8 200 of 6 LL (a 400 500— IWO CO NSTANTS O 400 - - c~ 300 _ He ~ 1 00 Cal o Social Security ~ 7 / Net Interest Payments J - l 1954 1959 1964 1969 1974 1979 1983 (est.) 500— TH R E E VAR IAB LES National Sense / ~ . - 300 _ by 8 200 _ z . A: _ g 100 cr LU O All Other .- . . __ __ - ~' _~ , ', Federal Aid (to states and localities) 1 1954 1959 1964 1969 1974 1979 1983 (est.) CALENDAR YEARS FIGURE 3-3 The federal expenditure equation. 1Federal aid includes Aid to Families with Dependent Children and Medicaid payments. SOURCE : USACIR, staff computations.

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78 tion. An ever-increasing number of federal benefi- ciaries (social security, civil service and military retirement, and Medicare recipients), expanded benefits, and indexed cost-of-living adjustments have combined to create a fiscal triole-whammY that is driving exPendi- tures up sharply. for the bulk of the increase in domestic federal spending. ,’ ~ _ _ i, _ a: _ _ These entitlement programs account Although substantial, the increase in actual outlays to date for federal defense programs does not reflect the full cost of our national defense buildup because we are still in the R&D phase for some of the major and most expensive weapon systems. Thus, as the buildup contin- ues, further increases in defense spending can be ex- pected unless a weapons ~stretch-out. policy is adopted. A FISCAL PROGNOSIS What will happen to federal and state-local spending over the next few years? I offer two forecasts: First, barring a major conflict or a serious recession, total federal spending should stop growing at a faster rate than the economy, due both to a slowdown in the defense buildup and to a freeze or a cutback in federal domestic spending. Second, there is likely to be very little in the way of real growth at the state-local level despite the concern about our ~decaying. physical infrastructure and the need to strengthen our schools. Let us look at the state-local prospects first. State-Local Spending Trends To a casual observer, the many state tax increases adopted in the 1981-1983 period might suggest that the tax revolt is over. However, a closer look at the evi- dence suggests a different interpretation. The Fiscal Crunch First, a major state tax increase in the post-Propo- sition 13 era is more likely to signal fiscal despera- tion than that the big spenders are once again in offi A state government now exacts a major tax transfusion from its citizenry only when it is apparent that the

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79 state is suffering a severe fiscal hemorrhage--a large and unanticipated revenue shortfall due to economic recession. In many cases, these recent state tax increases are scheduled to self-destruct in six months to a year, clear evidence that the memory of the tax revolt and public opposition to government expansion still shape state legislative behavior. Further evidence that the tax revolt is not dead is to be found in the fact that eight states will be con- sidering changes in their existing tax and expenditure lids this year and five states will be considering new limits. (Table 3-1 presents a summary of recent pro- posals to limit state tax increases and expenditures.) The message is clear: Do not let public sector spending grow at a consistently faster rate than the economy (Benker and Kenyon, 1984). Rainy Day Psychology A second reason for believing that state and local policymakers are not about to embark on a new spending spree can be traced to the widespread state fear of another major recession and the belief that when it comes there will probably be no federal bailout. A1- though a rapidly rising economic tide is now carrying up most of the state revenue ships, we have yet to see a commensurate rise on the state-local expenditure front. Why? Because most states are still replenishing their badly depleted cash balances. Keenly aware of these fiscal realities, 21 states in the last few years have set up revenue stabilization (.rainy day.) funds (USACIR, 1984:94-95). Economic Development Concerns Keen concern for economic development stands out as the third reason for believing that most state tax poli- cymakers will pursue fairly conservative fiscal policies over the next several years. In this case, economic development is one of those nice fuzzy terms that can be used to gloss over bitter interstate competition for investors' dollars. In fact, not in the last 30 years have state leaders evinced greater interest than they do now in attracting and holding business investment. The last two major recessions and the rise of the , _ _ ~

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84 footloose multinational and multistate firms have caused state leaders to become acutely sensitive to the need to create Ha favorable business climate.. Although this concern for economic development has been used to justi- fy larger appropriations for physical infrastructure and, in some cases, education, more often than not it has prompted state officials to pursue conservative tax policies. For example, we recently witnessed the astounding spectacle in Indiana where all the top state officials publicly pledged to repeal the worldwide unitary method of tax accounting in return for a promise from a Japanese firm to build a $15 million plant in Terre Haute. Federal Spending Prospects Any discussion of where we may be headed on the federal spending front must first concentrate on federal domestic programs. These programs have constituted the driving growth force over the last three decades (see Table 3-2). TABLE 3-2 Federal Expenditures (percentage of GNP) . Calendar Year Defense Domestic Interest 1954 11.2% 6.5% 1.3% 1959 9.3 8.0 1.3 1964 7.7 9.6 1.3 1969 8.1 10.5 1.3 1974 5.4 14.1 1.4 1979 4.6 14.7 1.8 1983 est. 6.1 16.1 2.9 SOURCE: U.S. Advisory Commission on Intergovern- mental Relations, staff computations. There are two reasons for believing that federal domestic spending may actually shrink in real terms over the next few years: the disappearance of four boosters that have constantly increased domestic expenditures during the

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85 last 30 years, and the pressures created by the federal deficit. The Disappearance of Four Expenditure Boosters During the past three decades, federal policymakers could rely on four easy-money options to expand domestic programs at virtually no political risk. Now, one by one, those expenditure boosters have been lost. Income tax booster Until recently federal officials could sit back and allow inflation and economic growth to push taxpayers automatically into higher tax brackets As a result, millions of middle-class taxpayers were pushed up into tax brackets that until recently had been the province of only the truly wealthy. This bracket creep has contributed greatly to the growing public discontent with the federal income tax. It led to the decision of the Congress to index the income tax starting in 1985, an action that will take the inflationary wind out of the federal income tax sails. Domestic Transfer Booster After the end of the Korean War, federal officials were able to shift vast sums from defense to domestic programs. This great change in expenditure priorities at no political risk provided the federal government with a fiscal advantage possessed by no state or locality. Since the Soviet invasion of Afghanistan in 1978, it has been necessary to reverse this process. As a result, federal policymakers are now forced to pull resources away from domestic programs to help finance the Penta- gon's growing requirements. Social Security Booster With virtually no political risk, Congress repeatedly raised social security tax rates during the 1960s and 1970s to finance broadened program coverage. These repeated social security tax hikes met with little public opposition because most of the public viewed them as higher insurance premiums needed to pay for better protection. Easy Votes in the Congress to raise social security tax rates are now a thing of the past. In fact, the 1983 social security tax hike was justified on the grounds that it was needed to ~save. the system, not to

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86 expand it. This same 1983 legislation actually trimmed some of the social security benefits, an action that would have been considered unthinkable a few years earlier. Deficit Finance Booster Public acceptance of deficit financing provided federal officials with their fourth expenditure booster: They could cover revenue short- falls by borrowing, thereby avoiding the political pain associated with tax hikes or expenditure cutbacks. In 23 of the last 24 years, the national government spent more than it collected, and for those 23 years the defi- cits totaled about $1.0 trillion. As illustrated in Figure 3-4, the deficit problem has been growing pro- gressively worse over the last two decades. Quantitative differences can have qualitative effects. The enormous size of the federal deficit has focused pub- lic attention on the federal government's addiction to deficit financing. As a result, federal policymakers are about to lose their fourth and last expenditure booster. The Deficit Crisis The second reason for believing that most federal domestic expenditures will soon be placed on the fiscal austerity chopping block is the imperative need to put a halt to the constantly increasing federal deficit. The enormous size of the federal deficit has now become the nation's number one economic worry. The size of the fed- eral deficit problem can be illustrated by a stunning intergovernmental comparison: The federal budget defi- cit for fiscal year 1983 was $24 billion greater than the total tax collections of all 50 state governments. THE GREAT COMPROMISE? It is becoming increasingly clear that the growing political demand to cut federal deficits will soon force Washington into the Great Deficit Reduction Compromise. As their price for agreeing to a deficit reduction plan, the liberals will probably succeed in slowing the growth in defense expenditures and in enacting a major federal tax increase. In return for their support for deficit reduction, the conservatives will demand and probably get two far-reaching concessions:

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87 Percent 20 — 18 — 16 — 14 — 12 — 10 — 8- 6 — 4— 2— O— 17% 1 2% 6% 5% 4% 3% 1955~9 1960 64 1965~9 197~74 1975-79 198~84 est. SOURCE: U.S. Office of Management and Budget, The Federal Budget for l9B4, Table 24, and USACIR staff computations. FIGURE 3-4 Federal budget deficit as a percent of total federal expenditures. 1. an across-the-board expenditure freeze or cut for most domestic programs, and 2. the enactment of a balanced budget amendment with some type of expenditure or tax lid attached. In pushing their demand for a balanced budget, the conservatives have a powerful weapon--the state shotgun behind the congressional door. Thirty-two of the re- quired 34 states have made application to the Congress for a limited constitutional convention to draft a bal-

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88 anced federal budget amendment. Congressional conserva- tives can also count on a populist, grassroots fiscal discipline movement (USACIR, 1984:19-20) to help carry them over the top. There is a new urgency to this issue because an initiative in California, just recently approved for the November ballot, would petition the California Assembly to call for a constitutional convention on the federal balanced budget issue or face suspension of their legislative sala- ries. So far, there has been no announced opposition to this ballot measure. Similar initiatives are circulating in Montana, Ohio, and Washington. . . . it was seven years ago that actions in California marked the beginning of a new era of fiscal discipline at the state level, once again California voters may spearhead a drive for fiscal discipline--this time at the federal level.* DE FACTO NEW FEDERALI SM The great changes that have swept across the United States since 1978 have produced a ode facto. New Fed- eralism. This new order is not the nice, neat, and orderly Sorting out. process for which political sci- entists and reformers yearn. Nor has it evolved along the tax turnback and program swap lines advocated by the Reagan administration. Rather, New Federalism, which actually started in the latter half of the Carter admin- istration, is a slow federal retreat along the entire federal aid front--action dictated both by growing fiscal stringency and conservative political ideology. Nevertheless, de facto New Federalism clearly represents a Sorting out. of sorts: Relatively less federal financing is going into state and local programs and relatively more federal financing is going into strictly national programs (defense, social security, and Medi- care) and into paying the interest on a $1.4 trillion U.S. debt. *After the article was written, the California Supreme Court removed this initiative from the ballot.

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89 The new, fiscally austere federalism can best be understood by comparing it to affluent sold federalism,. which began at the end of the Korean War and ended in 1978, the year of the Soviet invasion of Afghanistan and the California taxpayers' revolt: · Old federalism was characterized by steadily in- creasing state-local dependence on federal aid as the nation increasingly looked to Washington to set the domestic agenda. New federalism is marked by steadily decreasing state-local reliance on federal aid dollars as the country increasingly looks first to the locali- ties and then to the states to handle domestic issues. · Old federalism was intrusive in character--a stead- ily growing number of federal aid Strings and condi- tions were designed to alter state and local budgetary priorities and to race state and local fiscal engines. New federalism is becoming increasingly extrusive in character--the federal government is pulling aid funds and tax resources from state and local governments to strengthen the financing of its own national programs. · Old federalism represented a continuous but un- planned advance of the national government into areas that had heretofore been the exclusive province of state and local governments. New federalism represents a con- tinuous but unplanned retreat from federal positions staked out during the Great Society era. · Old federalism flourished in a political environ- ment that resolved the political and fiscal doubts in favor of social equity concerns, domestic public sector growth, and defense contraction. De facto New Federal- ism operates in a political climate that resolves the doubts in favor of economic development, defense expansion, and domestic public sector containment. Phase II of de facto New Federalism will most likely emerge in the wake of the November 1984 election as growing public concern about massive budget deficits will force federal policymakers to make far more painful choices than they have had to make thus far. Even now, two trends are clear: First, an increasing share of the federal budget will continue to be earmarked for pro- grams that are the sole responsibility of the national government--defense, social security, Medicare, and interest on the debt. Second, state and local officials will continue to operate in a bracing ado it yourself fiscal environment for the foreseeable future.

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9o REFERENCES Benker, K., and Kenyon, D. 1984 Fiscal discipline: lessons from the state experience. National Tax Journal 36(3):433-446. U.S. Advisory Commission on Intergovernmental Relations 1984 Significant Features of Fiscal Federalism, 1982-1983. M-137. Washington, D.C.: U.S. Advisory Commission on Intergovernmental Relations. U.S. Office of Management and Budget 1984 The Federal Budget for 1984. Washington, D.C.: U.S. Government Printing Office.