“Free” Government Money is Rarely Free

by Amy K. Frantz

The federal government gave out grants to state and local governments totaling more than $628 billion for fiscal year 2015.[1] Why wouldn’t states and local governments take grants from the federal government? Leaving aside the argument that the money the federal government gives away came from taxpayers in the first place, aren’t federal grants “free” money? A closer, more transparent look at federal grants and the impact they have on state and local budgets will show that the “free” money isn’t so free after all.

Federal grants are typically intended to supplement state and local government spending rather than take the place of some state and local spending. Thus receiving federal dollars does not generally result in less spending by state and local governments. This is known as the flypaper effect, which “results when a dollar of exogenous grants-in-aid leads to significantly greater public spending than an equivalent dollar of citizen income: Money sticks where it hits.”[2] Robert P. Inman writes of this phenomenon in a National Bureau of Economic Research (NBER) working paper discussing research from the late 1960s on how local governments tax and spend:

The empirical analyses of [James] Henderson and [Edward] Gramlich revealed something unexpected, however. An extra dollar of personal income increased government spending on the order of $.02 to $.05 but an equivalent extra dollar of grants-in-aid increased government spending by $.30 to often as much as a full dollar.[3]

Additionally, federal grants often come with strings attached, or conditions that state and local governments must meet, in order to receive federal dollars. The Congressional Budget Office (CBO) writes that these “conditions may be central to the program at hand, such as the requirements that school districts must meet to qualify for federal grants under No Child Left Behind; or they may have little direct bearing on the grant program, such as the requirement that, in order to receive highway funding, a state must set a minimum drinking age of 21.”[4]

One such string is a matching-fund requirement that state and local governments must contribute “a designated share of the cost of the program from their own resources.”[5] One example of a matching requirement would be federally funded highway grants, which typically require a 10 or 20 percent match from state and local governments in order to receive the remaining 80 or 90 percent funding from the federal government for a road project. Medicaid is another program with state matching requirements.

Another type of string placed on state and local governments by the federal government is a Maintenance of Effort (MOE) requirement:

MOE requirements are provisions of law that aim to prevent state and local governments from using federal funds to replace funds that states and localities would otherwise have used to pay for that program. MOE requirements take on a number of different forms, depending on the program. For instance, to receive their full allocation of Title I funds for the education of disadvantaged children each year, a local education agency must have spent on primary and secondary education in the preceding year at least 90 percent of what it spent the year before that from nonfederal sources.[6]

The Congressional Budget Office writes that matching or MOE requirements “can help ensure that state and local governments participate financially in programs that have local benefits and that the choices they make when administering grant programs align better with federal interests.”[7] State and local governments must remember that once they accept federal funds, they may not only be supplementing their own spending with federal dollars, they may be supplementing their own judgment and wishes with federal control over local programs.

Steven J. Anderson of the Kansas Policy Institute writes of the danger to state governments from accepting federal funds with MOE requirements:

Maintenance of Effort (MOE) requirements related to federal grants to the states have removed the power of a state’s elected officials to control their own budgets. The Congressional Budget Office clearly states the intent of these MOEs: ‘Federal grant programs provide a mechanism for federal policymakers to promote their priorities at the state and local levels by influencing the amount of money spent by state and local governments and the types of activities on which those governments spend their money.’

These MOEs bind governors and legislators to spending requirements with no regard to the state’s budget situation or governing priorities. The MOEs can most reliably be described as an addictive drug. One must maintain a certain level of the ‘drug’ to avoid a painful withdrawal.

Returning power to state elected officials, in terms of MOEs, requires a vigilant and proactive approach to mitigating the federal takeover of state budgets. Transparency in the grant application process combined with more aggressive oversight by a state’s elected officials is necessary to restrict the federal takeover of even larger amounts of budget.[8]

A prime example of local governments losing control of their own programs once they accept federal funds was highlighted in a Public Interest Institute POLICY STUDY earlier this year, “The Nanny State Is Expanding — And Private-Property Rights Are Decreasing.” As Deborah D. Thornton wrote in the Institute’s Study:

Dubuque is being required to alter their Section 8 low-income housing standards to not focus on the local needy citizens, but instead to attract and recruit new low-income people from areas outside of Iowa. The requirement is specifically to recruit low-income applicants and approved users of Section 8 housing vouchers to more closely reflect the demographics of Chicago.

The negative and unintended result of the HUD micromanagement of the Section 8 low-income housing program in Dubuque is already beginning. The new list of eligible applicants is expected to close this summer, and the wait time for housing vouchers could be two years or more. There is not enough money to fund the required number of vouchers. The administrative burden imposed by HUD is significant, and Dubuque is required to follow their every direction for the next five years or more.

Though many local elected officials probably believe they can retain local control, if you take the federal government’s money you must play by their rules.[9]

Just what is the impact on state and local government budgets from accepting federal grants? Dr. Eric Fruits, President and Chief Economist at Economics International Corp. and adjunct professor of economics at Portland State University, studied the period from 1972 to 2012 and, controlling for state-by-state differences in economic and demographic factors, has found that across states as a group, each dollar of additional federal grants to states is associated with a total increase of 82 cents in new state and local taxes.

Dr. Fruits also looked at each individual state to determine the impact on state and local government budgets from accepting federal grants. The results show that:

Iowa has a larger ratchet effect than states as a group. Statistical analysis controlling for the economic and demographic factors that vary across states and over time indicates that — holding other variables constant — each additional dollar of federal intergovernmental transfers to Iowa is associated with $1.11 in additional taxes, charges, and other state and local own source revenue.

In 2012, Iowa state and local governments received $7 billion in federal intergovernmental transfers and spent $22.1 billion raised from state and local sources.

When accepting a federal grant, state and local governments, and taxpayers, need to realize that grant funds are not just “free” money granted by the federal government. Elected officials and taxpayers must keep in mind that there are usually strings attached to the federal grants, such as those that require matching funds from the state or local government or maintenance of effort requirements, which are likely to lead to additional spending at the state or local level. We need to make sure that the benefits from accepting federal grants are worth the extra spending, and thus the extra tax dollars needed from taxpayers that will result from accepting federal grants.

[1] Robert Jay Dilger, “Federal Grants to State and Local Governments: A Historical Perspective on Contemporary Issues,” Congressional Research Service, March 5, 2015, <https://www.fas.org/sgp/crs/misc/R40638.pdf> accessed October 28, 2015.
[2] Robert P. Inman, “The Flypaper Effect,” NBER Working Paper No. 14579, Issued in December 2008, <http://www.nber.org/papers/w14579> accessed November 5, 2015.
[3] Ibid.
[4] “Federal Grants to State and Local Governments,” Congressional Budget Office, March 2013, p. 12, <https://www.cbo.gov/publication/43967> accessed October 29, 2015.
[5] Ibid., p. 16.
[6] Ibid., p. 17.
[7] Ibid., p. 16.
[8] Steven J. Anderson, CPA, MBA, Senior Adjunct Fiscal Policy Fellow, “Maintenance of Effort: The Federal Takeover of State Budgets,” Kansas Policy Institute, July 2015, <http://www.kansaspolicy.org/ResearchCenters/BudgetandSpending/BudgetandSpending Studies/127824.aspx> accessed November 6, 2015.
[9] Deborah D. Thornton, “The Nanny State Is Expanding — And Private Property Rights Are Decreasing,” Public Interest Institute POLICY STUDY, June 2015, <http://www.limitedgovernment.org/ps-15-6.html> accessed November 6, 2015.
[10] E-mail with individual state results from “Impact of Federal Transfers on State and Local Own-Source Spending,” by Dr. Eric Fruits, October 6, 2015.

Amy K. Frantz is Vice President of Public Interest Institute.

IOWA TRANSPARENCY NEWSLETTER is a monthly newsletter reporting on government transparency in our state.

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