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OCR for page 71
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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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
OCR for page 74
16-
14-
10-
8-
6-
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2-
O-
1953 58 63 68
Calendar Years
74
Percent
26-
24-
22-
20-
18-
_ _
/1~
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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
OCR for page 75
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).
OCR for page 76
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-
OCR for page 77
77
u,
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He
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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.
OCR for page 78
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
OCR for page 79
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
, _ _ ~
OCR for page 80
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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:
OCR for page 87
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.
Representative terms from entire chapter:
deficit financing
