by Robert Kleine, Vice President and Senior Economist

This Advisor discusses the ramifications of replacing federal entitlement or categorial prrgrams with proposed federal block grants to state and local governments.

Introduction

As part of efforts to reduce the federal budget deficit and give more responsibility to the states, Congress is currently debating legislation that would consolidate a number of social programs into block grants, giving the states responsibility for administering the programs. Nine block grants are being considered; cash assistance/Aid to Families with Dependent Children (AFDC), child protection, child care, food and nutrition, social services, employment and training, health, housing, and Medicaid.

On March 24, 1995, the U.S. House of Representatives passed (234 to 199) the Personal Responsibility Act (House Resolution 4) to reform the nation’s welfare system. The bill would replace dozens of federal welfare assistance programs with five block grants to the states. (See page 8 for an overview of proposed block grants.)

Block grants are federal funds provided to state and local governments for a wide range of programs within broadly defined areas, such as housing. State and local governments are given considerable latitude in deciding which programs to fund and which populations to serve, although programs and services are expected to relate to the overall goals of the block grant program. Federal regulations generally are kept to a minimum.

Block grants have been used for a number of years but have made up a relatively small percentage of total federal aid to state and local governments. In the current fiscal year state and local governments are expected to receive $231 billion of federal aid, with 89 percent allocated to state governments. The largest share is for health programs (44 percent), primarily Medicaid. The other components are welfare, food programs, and housing (23 percent); education, training, and social services (15 percent); transportation (9 percent); and other (9 percent) . These grants are mostly entitlements; a number are shared federal-state programs. There are currently 15 block grant programs that account for 7.5 percent of federal aid to the states.

Federal Aid to Michigan

In FY 1995–96 federal aid to Michigan state government is projected at $7.304 billion, and aid to local governments at $850 million. As shown in Exhibit 1, the largest state grant-in-aid programs are for Medicaid, AFDC, highway planning and construction, Chapter 1-Local Education Agencies, and the school lunch program. Funding for the programs affected by the block grant proposal that passed the U.S. House last month totals about $1.5 billion.

In the past six years federal aid to Michigan state government has increased 76.8 percent, while the total state budget has increased only 43 percent. The largest dollar increases have been for Medicaid, highway planning and construction, education-school lunch and Chapter 1-Local Education Agencies, AFDC administration, and the job opportunities and basic skills program (JOBS). Current block grant programs total about $490 million. The nine block grant programs that have existed since the early 1980s increased only 5.6 percent from FY 1990 to FY 1996.

Issues and Concerns

Block grants are attractive to many state-local and federal policy makers because they offer the potential to reduce federal spending, the role of the federal government, and red tape and to increase flexibility for state and local governments. Many also expect that (1) local control would mean improved service for clients due to better understanding of local needs, (2) programs could be simplified without the restrictions imposed by federal oversight, and (3) costs could be reduced through increased efficiency not currently possible under federal regulations.

Creating block grants would have several significant effects, including increased flexibility, reduced federal spending, and lower service and benefit levels.

Increased Flexibility

Block grants usually have fewer restrictions than categorical grants. Decisions about which services to provide and how to provide them would be made by state and local governments rather than the federal government. This is desirable in many cases, but not all.

In some instances minimum national standards may be desirable, for example, assuring that those in need have a certain amount of money available for food. A study by the General Accounting Office of the 1981 Reagan block grants found that over the years new funding constraints were added because of concerns that the states were not meeting needs.

Reduced Federal Spending

Block grants can take pressure off the federal government in two ways: Their initial funding is usually lower than that of the programs they replace, and they usually do not grow as fast as entitlement or other categorical programs. For example, nine block grants were created in 1981 as part of President Reagan’s New Federalism. Five of these have decreased or remained at about the same spending level. The other four have experienced sporadic growth. In total the nine block grants increased from $10.8 billion in 1983 to $11.4 billion in 1993, a 27 percent decline adjusted for inflation.

Lower Service Levels and Benefits

In contrast, entitlement programs such as food stamps and Medicaid grow annually because benefits typically increase with inflation and the number of recipients usually increases. From 1983 to 1993 means-tested entitlement programs increased about 89 percent adjusted for inflation.

However, even without block grants there is great pressure to reduce the federal budget deficit, which means that many of these programs would likely be reduced anyway. Many states seem willing to take the chance that they might do as well with block grants and will gain more flexibility.

As discussed above, in future years block grants may well be funded at a considerably lower level than existing programs. In addition, because block grants are usually nonmatching grants, they provide less incentive for states to spend their own resources.

Matching grants stimulate spending because they are like a price cut. If a state wants to increase AFDC spending by one dollar, with matching grants it costs the state only 20 to 50 cents, depending on the federal matching rate. Under a block grant it would cost the state a dollar. States, therefore, are likely to spend less on programs that formerly were entirely federal responsibilities.

There are several specific concerns about block grants, particularly since the current proposals are more far-reaching in their effect than earlier efforts. The roughly 100 programs (out of about 600 federal grant programs) that could be combined under current proposals total approximately $30 billion, or 13 percent of federal grants to state and local governments. In addition, the food stamp and Supplemental Security Income programs (about $50 billion), which are grants to individuals rather than states, will be affected.

The first major concern is that federal responsibility for programs that are national in scope and provide direct economic assistance, such as AFDC and food stamps, will be reduced. The need for these programs is related to national economic trends over which the states have no control. Also, only the federal government can assure equity by requiring a comparable level of assistance in every state. This is particularly important given the unequal fiscal capacity among the states. (This issue is discussed in detail below.)

Second, the elimination of the requirement for states to demonstrate a “maintenance of effort” or to provide matching funds in order to receive federal funds could result in a state reducing its own spending for these programs or electing to spend only the amount included in the block grant.

The difference between relying on the federal government and relying on the states to determine benefits is illustrated by the spending patterns for AFDC and food stamps. Since 1970 the average maximum AFDC benefit for a family of three (which is determined by state governments) has fallen 47 percent adjusted for inflation, while the value of food stamps has kept up with the rate of inflation.

Another consequence could be a lowering of standards. When federal day care requirements were eliminated as part of the Reagan block grants, the state of Texas managed to care for about 16 percent more children at almost 20 percent less cost to the state. But Texas altered the minimum ratios of staff to children to allow one staff member to care for as many as 13 children. The federal standard had required that one staff member care for no more than four children.

Third, many of the programs included in the block grants will be affected by a downturn in the economy. States could be hard pressed if needs increase at the same time revenue growth slows. The result could be higher taxes or reduced services.

Fourth, because block grants include only minimal federal regulations for data collection, verification, and reporting, accountability for the expenditure of federal funds will likely be reduced. However, legislation has been drafted that will require states to provide in a report annually, data that permits an assessment and comparative analysis (with state ranking) of the extent to which states have met certain purposes and national goals specified in the legislation.

Fifth, the expected administrative savings may be overstated and in any event will be small compared to the reductions in funding that will accompany the block grants. An Urban Institute analysis found that the block grants created during the Reagan administration reduced spending by about 12 percent but achieved only 2 to 5 percent in administrative savings.

Finally, state flexibility to experiment could be reduced. Current entitlement programs provide a 50 percent federal match for state funds, which enables states to attempt more costly policy options than might be possible when 100 percent state funding is required. However, some view this as an opportunity to change business as usual and become more innovative. Many states are already “reinventing government,” and there is strong pressure for this to continue despite policy changes at the federal level.

Fiscal Effects

The current proposals allocate funds to the states based on FY 1994 spending levels (or the 1992–94 average) and, in most cases, freeze these levels for five years. States may transfer between 20 and 30 percent of most block grants to other block grant areas and may carry forward funds to the next fiscal year.

According to the Congressional Budget Office, the block grant legislation would save about $76.3 billion over five years: $6.1 billion in FY 1996 and $21.3 billion in FY 2000. About 25 percent, or $21.4 billion, of the projected savings come from restricting benefits for legal aliens (a provision that may not make the final legislative cut). Projected spending under the new legislation in FY 2000 will be about 8.2 percent below projected spending under current law. This figure is based on projected baseline spending, however, which takes into account inflation and caseload changes.

Block grant supporters say that use of this baseline overstates the magnitude of the cuts, although we believe this is a legitimate method of analysis since real cuts will be required if funding does not keep up with inflation and caseload increases. It is true, however, that projected spending on these block grants will increase from $168.4 billion in FY 1995 to $239.1 billion in FY 2000.

A freeze in funding may be the best states can expect in view of the experience with the 1981 block grants. As shown in Exhibit 2, in Michigan block grants were implemented with an overall funding reduction of 20 percent, and from 1985 to 1994 most were reduced sharply (adjusted for inflation), with declines ranging from 10 to 50 percent.

According to estimates prepared by the U.S. Department of Health and Human Services the current block grant proposals will reduce aid to Michigan state government by about $2 billion over the next five years. The loss will be about $150 million in FY 1995–96 and increases each year as funds fall short of inflation.

The estimates are reductions from baseline projections; actual funding will increase over the five-year period. This funding level, however, is likely to result in a reduced level of services. Note that these estimates are from the Clinton administration, which opposes many of the changes and could be biased. Completely reliable estimates are difficult to obtain at this stage of the process.

Block Grants and Federal-State Fiscal Relations

In an ideal fiscal arrangement, the national government would provide special financial assistance to those state-local systems in greatest fiscal need. Why? Because this additional (and unconditional) federal aid would enable the most fiscally disadvantaged jurisdictions to provide a minimum level of services that a highly mobile and interdependent nation requires. Such minimum levels may not be sustained by poor jurisdictions because to do so they would have to impose extraordinarily heavy taxes on their citizenry. This fiscal equalization task can be viewed as a unique federal responsibility because the national government possesses the widest tax reach and the greatest fiscal power.

The new Republican majority in Congress is suggesting that this responsibility should be abrogated and that certain programs be turned over to the states, total federal aid to the states be reduced, current specific grants be rolled into block grants, and the grant amount reduced. If these changes are enacted they will have very uneven effects on the states.

States vary greatly in their ability to generate taxes and to shift them to nonresidents. For example, energy-rich states like Alaska and Wyoming are better able to raise taxes and shift them to nonresidents than are Mississippi and Alabama—jurisdictions characterized by anemic tax sources and a relatively poor ability to shift taxes to nonresidents.

If states have to rely on their own revenue-raising power to provide services previously provided by the federal government, one of two things will happen: Some states will be forced to levy well above average tax rates to maintain current service levels or services will have to be reduced.

State Fiscal Capacity

One measure of a state’s ability to raise revenues is per capita personal income. This is an imperfect measure, however, as it fails to reflect the diversity of revenue sources and the ability of states to “export” taxes, that is, to levy taxes that are ultimately paid by nonresidents, such as taxes on energy. The Advisory Commission on Intergovernmental Relations (ACIR) has developed a measure—the Representative Tax System (RTS)—that corrects for these shortcomings.1 Both per capita personal income and the RTS measure as a percentage of the U.S. average, by state, are shown in Exhibit 3.

For many states the two measures do not vary significantly; for some they do. For example, based on personal income, Alaska has a fiscal capacity (revenue-raising ability) 10 percent above the national average. Using the RTS measure, Alaska is 39 percent above the national average, largely because it generates significant revenues from taxes on petroleum, a large share of which is exported to nonresidents. For Michigan, the RTS measure is slightly below the personal income measure, 94 compared with 98, indicating that Michigan’s fiscal capacity is below the national average for both measures.

These numbers point out the disparity in the revenue-raising ability of the states, indicating that some states must levy much higher taxes to provide an average level of services than other states. For example, the RTS in Mississippi is 68, meaning that the state would have to levy tax rates 32 percent above the national average to maintain an average level of services. Near the other extreme, the RTS for Connecticut is 130, meaning that in that state an average level of services could be provided with tax rates 30 percent below the national average. This points up the inequity of shifting federal responsibilities to the states without some mechanism for addressing the disparity in resources.

In a 1990 study (using 1987 data) the ACIR calculated the gap between expenditure needs and revenue-raising ability for each state. Expenditure needs were calculated by adjusting actual expenditures for differences in costs of providing public services and in workload measures, such as population living below the poverty level, vehicle-miles traveled, and number of school age children. The results are shown in Exhibit 4.

In Mississippi, revenues raised with average tax rates (equal to national average) fell about $1,300 per capita (RTS) short of meeting expenditure needs, or 42.6 percent of representative expenditures (actual expenditures adjusted for costs and workloads). In Connecticut, revenues raised with average tax rates exceeded expenditure needs by $1,275 per capita, or 51.8 percent of expenditures. In Michigan, revenues raised with average tax rates fell short of expenditure needs by about $350 per capita, or 12.1 percent of expenditures.

When federal grants-in-aid were added the disparities were reduced but remained large. For example, in Mississippi, revenues fell 36.3 percent short of meeting expenditure needs compared with 42.6 percent without federal aid. For Michigan, the shortfall decreased from 12.1 to 9.9 percent.

These data provide evidence that reduced federal aid and increased responsibilities for states will serve to increase inequities among the states, with citizens in poorer states paying higher taxes or receiving inferior services.

Conclusion

Based on previous experience and the clear need to reduce the federal budget deficit it is almost certain that the shift to block grants will significantly reduce federal aid to state and local governments. No one should be under the illusion that the funds can be easily replaced. Although fiscal conditions have improved from their depressed level of the early 1990s, states have limited financial reserves available, though Michigan has more than most. When economic growth begins to slow, however, tax cuts in Michigan and other states will rapidly deplete available reserves.

In the past states have been more willing than the federal government to raise taxes to address a fiscal crisis, but the anti-tax mood is likely to preclude significant tax increases by the states. One option might be for the states to cut aid to local governments, which could force up property taxes. The only other alternative is to cut funding for state programs such as education and social services.

The result of the initiatives to move to block grants and cut federal spending will be to increase the role of state and local governments and to reduce considerably the level of services. When this becomes apparent to the public there may be a backlash, as little popular support exists for sharply lower government services. The voters want government to be more efficient and taxes to be lower, but they do not want to lose benefits such as Social Security, Medicare, child nutrition, and student loans.

The block grant experiment is a risk for the states. The result could be sharply reduced services for clients, particularly in states with low fiscal capacity. Conversely, this could be an opportunity for states to find better, more efficient methods to provide these services. In fact, they may be forced in this direction. It is hoped that, with more responsibility and more flexibility, the states will be equal to the challenge of providing the current (or a better) level or services at a lower cost.

1Revenue raises ability, or fiscal capacity, is the hypothetical ability of a state and its local governments to raise revenues to support public services. RTS measures revenue-raising ability by estimating the tax yield that would result from applying a standard, representative set of tax base definitions and tax rates in every state.



Copyright © 1995

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