J. OF PUBLIC BUDGETING, ACCOUNTING & FINANCIAL MANAGEMENT, 20 (1), 46-71
SPRING 2008
THE CHANGING FEDERAL GRANT STRUCTURE
AND ITS POTENTIAL EFFECTS ON STATE AND LOCAL COMMUNITY
DEVELOPMENT EFFORTS
Jeremy L. Hall*
ABSTRACT. Changing political landscape often renews the call for
dramatic changes to federal community and economic development
grant-in-aid programs. The most dramatic proposal in recent years
was President Bush’s 2006 call to consolidate federal assistance
programs for communities into a new block grant known as the
Strengthening America’s Communities Initiative (SACI). This
conceptual study reviews key characteristics of intergovernmental
transfers including grant types, features, changes in the
intergovernmental fiscal environment, the fungibility/flypaper debate,
and the symmetry/asymmetry response of governments to declining
intergovernmental revenue. The effects of intergovernmental
transfers on state and local governments are connected to
differences in grant design features. Potential fallout from proposed
or similar changes to grant structure is discussed using the SACI
proposal as an example.
INTRODUCTION
Over time, the relationships between U.S. federal, state, and local
governments have become increasingly complex as government has
grown in size and breadth of services provided, as the number of
local governments and special districts have increased, and as the
roles of distinct layers of government have become blurred through
--------------------------* Jeremy L. Hall, Ph..D., is Assistant Professor, Government and Public
Service, University of Alabama at Birmingham. His research concentrations
include economic development, public policy, government capacity, public
performance measurement, and fiscal federalism.
Copyright © 2007 by PrAcademics Press
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THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
47
interaction among, rather than separation by, policy areas. Over time,
the federal government has increased its stature in policy arenas
previously left to state discretion. One of the primary mechanisms
through which the federal government has acted to induce state
policy reactions and increase state efforts is through
intergovernmental fund transfers.
Students of government have long been interested in the effects
federal grants have on the sub-national governments they seek to
assist. This study reviews the fiscal federalism literature to identify
key characteristics of the federal intergovernmental transfer system,
and to identify the effects of changing levels of federal grant support
on state and local government budgets. This literature is brought to
bear on the 2006 proposal to restructure federal community
economic development assistance through consolidation of programs
into a new block grant under President Bush’s Strengthening
America’s Communities Initiative.
BACKGROUND:
FEDERALISM AND INTERGOVERNMENTAL RELATIONS
Intergovernmental relations pertain to the dynamic of interaction
between the levels of government in the American system. When
considering issues of intergovernmental finance, such as taxing and
spending, the term fiscal federalism is applied. “From its beginnings,
the fiscal system of the United States has been committed to the
principle that multiple layers of government are the preferred
structure for the financing and provision of government services. The
U.S. Constitution, through the Tenth Amendment, expressly protects
the rights of states to pursue their own fiscal agendas, provided those
agendas do not conflict with clearly legislated federal objectives or
constitutionally protected individual rights” (Inman, 1988, p. 33).
Federalism in the U.S. has undergone a major shift during the
twentieth century from a model wherein each level of government has
its own realm of duties, to a model where multiple layers of
government may be involved in providing a given service. This general
trend reflects increased power of the national government in dealing
with affairs that were previously the sole responsibility of the states.
This shift has been exacerbated by the increase in direct interaction
between the federal and local governments (in addition to federalstate relations) during the period following the New Deal (O’Toole,
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2000). Grants-in-aid soon became a very powerful tool of fiscal
federalism. The Grants-in-aid system has enabled the federal
government and Congress to wrest control of programs from the
states, or at least to exert considerable influence over them.
Federal grants-in-aid have a long and convoluted history, but are
generally acknowledged to have begun in the nineteenth century,
when the federal government granted land to state governments for
the establishment of state ‘Land Grant’ universities (Nathan, 1983, p.
43). Hines and Thaler (1995) alternatively suggest intergovernmental
aid was initiated in 1835 when, upon paying off the national debt and
forecasting future budget surpluses indefinitely, Congress decided to
distribute leftover funds to the states on the basis of population for
the purpose of financing public works. Cash grants are the norm
today. Use of the grant was not elevated to its current state of
prominence until the middle third of the Twentieth Century, due
primarily to the implementation of new programs in the 1930s and
1940s, such as Roosevelt’s New Deal and Johnson’s Great Society
(Kettl, 1983). Theoretical literature regarding federal granting
behavior and its related outcomes has only developed in the last
quarter-century, primarily because cash grants themselves are such a
recent development in federal fiscal relations. As Nathan (1983, p.
47) observed, “It is not surprising that the theoretical literature on
grants does not have an extensive empirical base.”
Intergovernmental Grants in Fiscal Federalism: Conceptual Issues
Since the inception of grant making as a fiscal tool, various types
of grants have been developed and utilized. They differ in features
such as the method of allocation, the level of discretion afforded to
the grantee, and the use and level of matching requirements. The
primary distinction in grant types is between unconditional grants and
conditional grants. Grants may have varying degrees of conditions
attached to them, and may not fit neatly into one group or the other.
However, unconditional grants refer to transfers from the federal
government with no strings attached—no restriction on the types of
expenditures that may be undertaken, and no requirement for local
spending (matching funds). Conditional grants impose limitations on
fund use, require local government matching funds, or impose other
legislative or administrative requirements as a condition for receipt.
THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
49
As an example, general revenue sharing transferred lump sums of
money to the states without any requirement for their use; this type of
transfer epitomizes unconditional grants. On the opposite end of the
spectrum are conditional grants, which require state matching funds,
and/or which are to be spent on narrowly defined projects, or for
specific purposes. Conditional grants reduce local discretion, and
increase the federal government’s policy influence. In between are
block grants which transfer lump sums of money to state/local
governments for spending in certain policy areas, such as social
services or community development. Generally such grants defer
discretion for spending to the states with general federal guidelines.
One of the key distinctions between conditional and unconditional
grants is the matching requirement. Matching grants require the
recipient government to expend own-source revenue on the funded
program. Matching requirements may vary significantly from zero to
unity with federal funding or beyond. The greater the matching
requirement, the greater the conditionality of the grant, other things
being equal. Unconditional grants include non-matching grants, such
as revenue sharing or block grants; conditional grant types include
matching grants, and project (categorical) grants.
It should be noted that other things are usually not equal. Chubb
(1985) introduces political and bureaucratic considerations to the
model of fiscal federalism, taking the intergovernmental fiscal system
as a hierarchy of principal-agent relationships wherein the federal
political superiors are able to control state and local actions through
the federal bureaucracy. However, Meier and O’Toole (2006) show
that bureaucratic values moderate political control in bureaucratic
outputs, noting that an appropriate principal-agent interpretation
“would have to be rather convoluted” to explain their results (p. 188).
Therefore, a complete understanding of the fiscal response of state
and local governments to various grant structures can only be
obtained by incorporating political and other considerations into the
relevant economics.
Another qualitative difference among grant programs is the
degree of targeting versus distributional equity. Formula grants,
which are distributed in lump sum to a government on the basis of
population (or some other designations), seek to evenly distribute
funds across all recipients or beneficiaries. Formula grants to
schools are based on the number of students, such that each student
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HALL
theoretically receives the same benefit from the grant. On the other
hand, federal grants may be targeted to specific areas on the basis of
need identified by income, poverty, or some other variable. Targeted
grants seek to equalize differences between wealthy and poor areas
or individuals. This structural difference helps us understand the
political goals that grant programs may serve for both recipients and
grantors.
Federal policymakers’ goals and objectives have changed over
time, generally corresponding to changes in party control in Congress
and the presidency. The changes in federal grant-making policy have
largely been attributed to differences in opinion regarding how aid
should be distributed. First, there is a divide between those who
favor targeting grant monies to areas that demonstrate the most
need and those who favor equal distribution of funds on the basis of
population. General revenue sharing is advanced as a means of
achieving horizontal equity across geographical areas (Quigley &
Rubinfeld, 1986). Categorical or project grants, on the other hand,
are the predominant mechanisms for targeting aid to specific areas
(Aronson & Hilley, 1986).
A second divide pertains to the type of grant that should be used;
namely, unconditional grants (such as revenue sharing or block
grants) versus conditional grants (such as categorical or project
grants). This difference entails a decision regarding the relative level
of policy control the federal government wishes to maintain vis-à-vis
state/local grant recipients. Categorical grants typically come in the
form of project grants, which are competitive in nature, and often
involve stringent requirements for how or for what purpose they may
be spent (federal discretion). On the other hand, revenue sharing or
block grants tend to favor state/local control over grant funds, with a
vast reduction in federally-imposed spending restrictions (local
discretion) (Conlan, 1984; Aronson & Hilley, 1986). Block grants are
a hybrid grant form in that they allow state discretion in
administration, but are limited to expenditure within certain topical
categories.
Although typically assumed to entail less federal
discretion, block grants can be manipulated, as they were by
President Carter, to greatly reduce state and local discretion (Conlan,
1984).
These two typological areas overlap in that conditional grants
tend to meet the needs of both increased federal control and
THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
51
targeting, and as unconditional grants serve to devolve responsibility
to the states and equally distribute funds. History has demonstrated
ideological differences along these lines, with Democrats favoring
targeting and conditional grants, while Republicans typically support
equal distribution (not to be confused with “equalization,” which is
often coterminous with targeting) and a decreased federal role in
dictating how funds should be used—typical of unconditional grants
(Schneider & Ji, 1990).
Determining Participation in Federal Grant Programs
There are two schools of thought regarding participation in federal
grant programs.
Some suggest that the federal government
determines who will or will not receive aid. The fact that a federal
decision must be made is implicit. However, Rich (1989) suggests
this view should be expanded to include considerations of recipient
government preferences; that is, governments may choose, for
whatever reason, not to receive a particular federal grant. Recipient
discretion is essential to understanding the effects that federal grant
spending might have on state budgets and to explaining what actions
states take, such as nonparticipation. Stein (1984) finds that local
governments avoid the negative fiscal and political consequences of
federal aid, which suggests that states/localities do not necessarily
participate just because they are deemed eligible. That is, they are
utility maximizers, not budget maximizers.
In summarizing previous models of federal grant-making, Rich
(1989, p. 198) explains:
The major flaw in the models of distributive politics…is an
overemphasis on a centralized, top-down view of policy
distribution. While the subject of inquiry is the distribution of
federal expenditures, most studies have failed to incorporate
federal features into their conceptualizations of the dynamics
of policy distribution; that is, by focusing on the role of
presidents, legislators, and bureaucrats, scholars have
ignored a class of participants that have become key actors in
the distribution of federal aid—the recipient jurisdictions.
Indeed, for many federal programs, state and local
governments are the key decision makers in regard to the
distribution of federal aid, for they are the ones who decide
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HALL
whether or not to apply for aid, how much to ask for, and how
often they will seek assistance.
Federal government sets policy and makes funds available, but subnational governments make choices about programs the federal
government has put in place.
The opposing view is that budget maximization may take the
place of utility maximization as Leviathan governments seek to
increase their size and power (Quigley & Rubinfeld, 1986). Some
government recipients frame the grant decision in terms of how to
spend, whereas others frame the issue in terms of whether to spend
or reduce taxes (Nathan, 1983). Lower-level governments make
choices that impact the influence federal grants may have.
Grants are also used as electoral tools; congressional leaders use
their clout with federal agencies to direct grant funds to their district
to build political capital necessary for reelection. On the flip side,
bureaucrats may allocate grant funds strategically to maintain
influence with key congressional leaders (Rich, 1989). Congressional
earmarks are specially-tailored bits of legislation for pet projects of
the Congressperson’s choosing. Earmarks are typically for specific
tasks and projects, and closely resemble categorical project grants.
These powerful political tools may be used to garner electoral
support, and unlike most federal grants, the preferences are
determined by the local government, perhaps in negotiation with their
delegate(s).
Rivlin (1991) advocates a significant shift in federalism for the
future: “the states should have much clearer responsibility for most
kinds of public investment, especially for improving skills of the labor
force and upgrading public infrastructure. The federal government
should concentrate on a different set of missions, including
interaction with the rest of the world, strengthening social insurance,
and contributing to national saving by running a surplus in the unified
federal budget” (Rivlin, 1991, p. 3). Such drastic differentiation of
goals and responsibilities would represent a complete reversal of
intergovernmental relations, returning the nation to a state of dual
federalism, as it was through the early 1900s.
Rivlin’s view conforms to Peterson’s (1995) functional and
legislative theories of government activity. Each level of government,
through unique resources, conditions, and expertise, is able to
THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
53
provide certain services with greater efficiency than other levels of
government. Peterson argues that state and local governments
should be involved in developmental policy, while the national
government should concentrate on redistribution to alleviate inequity
across areas.
While Peterson might argue that the federal
government should have little or no role in development, he could
conceivably argue that they have a legitimate role in redistributing
wealth. In this scenario, the purest form of federal grant would be
targeted to areas of economic need (redistribution), with no
restrictions on the ultimate use of those funds (preserving the state’s
role to carry out development). Federal grants to distressed areas
would generate effects that lead to equalization over time, through
economic improvements resulting from the grant-funded activities.
Neither argument has been so widely agreed-upon to drastically
alter the course of federal policy toward intergovernmental transfers.
In fact, it is implicit in the nature of federal grants that strings come
attached. “[T]he federal government has provided intergovernmental
aid for two reasons, to give financial assistance to often hard-pressed
state and local governments, and to induce these governments to
administer programs with national goals” (Kettl, 1983, p. 24,
emphasis added). Kettl (1983, p. 42) adds that these two goals have
always been incompatible—every grant recipient desires maximum
discretion in using it, and every donor wants to maintain at least
some control over the money given; “the federal government never
gives money without strings attached.”
Levine and Posner (1981) observe that federal grants entice
state and local government participation by lowering the cost to the
sub-national governments of performing the aided activity. Perceived
cost reduction leads to reduced policy discretion on the part of state
and local governments as they invest own-source revenue in projects
of federal interest rather than programs of their own preference.
Schneider and Ji (1990, p. 409) note, “Reductions in aid and the
move away from targeting, which resulted from changing conditions
and shifting ideologies at the national level, clearly affected the
incentives and propensities of local governments to apply for aid.”
Not only do state and local governments have a choice, but the extent
of that choice is changing over time with changes in the structure of
the federal granting system.
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Discretion, or conditionality, is directly related to matching
requirements. The federal government may desire to increase local
investment in particular types of service, and may communicate that
desire through requirements that grantees contribute a percentage of
the total project cost. Grants may come with (conditional) or without
(unconditional) match requirements and the level of required match
can vary significantly. Matching requirements imply that local
spending is fostered, which translates into increased debt, or
increased taxes, or substitution for some other local program. At any
rate, matching requirements should lead to an increase in state and
local government spending levels (Gramlich, Courant, & Rubinfeld,
1979). The following section clarifies the relationships between
federal grant features and state/local budgetary effects.
Effects of Federal Funds on State Budgets: Flypaper v. Fungibility
The majority of existing federal grants literature, both conceptual
and empirical, addresses how sub-national recipients treat federal
grant funds in their budgets. Two conflicting perspectives—fungibility
versus flypaper—dominate discussion. Fungibility refers to the ability
of state and local governments to use federal funds as a replacement
for locally generated revenue. Thus, if a state received a federal
grant in the amount of $1 million, those funds would be said to be
fully fungible if the state reduced the tax burden on its citizens by the
same amount. The net effect on state spending would be nil; the
state would continue to expend at its preferred level in spite of the
grant receipts. The flypaper effect signifies that the local government
uses the federal grant to increase spending over and above its
preferred level. Flypaper occurs when state/local spending increases
by less than the amount of a grant, but greater than the increase that
would occur from an equal increase in local income (Volden, 1999).
The flypaper effect is best summarized as “grant funds [that] tend to
be spent rather than passed on to constituents via tax cuts” (Logan,
1986, p. 1304). For example, if state spending were $10 million
prior to receiving a $1 million grant, post-grant state spending might
be $10.8 million. If the $1 million grant had been distributed among
the jurisdiction’s constituents rather than to the state, the state
spending level might only increase to $10.1 million. The theoretical
explanation for flypaper’s existence is referred to as fiscal illusion.
Simply, local residents perceive the burden of grant funds to fall
disproportionately on residents of other jurisdictions. Empirical
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THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
55
evidence suggests that some degree of flypaper effect occurs,
causing the money to “stick where it hits” (Logan, 1986, p. 1304).
Funds are spent rather than passed along to constituents through tax
cuts.
Discussion in the literature surrounds the degree of flypaper
effect observed (Hines & Thaler, 1995). In his statements regarding
the distribution of the federal surplus to the states in 1835, Henry
Clay predicted that the effects of this distribution would stimulate
state spending by much more than economic theory suggests (Hines
& Thaler, 1995). A grant reduces the price that the recipient
government has to pay, making the funded activity more attractive
than it would have been without the federal assistance (Levine &
Posner 1981). Nathan and Doolittle (1985) found that in general
state/local governments have good reasons for avoiding substitutive
behavior with federal funds, including “unreliability of federal aid,”
and the fact that “federal regulations prohibit or discourage
substitution in many programs” (p. 54). Empirical evidence has
“found time and again that the expenditure stimulus to local public
programs…far exceeds that from equal increases in private income”
(Gamkhar & Oates, 1996, p. 501). Moreover, “[a]ll studies report
some degree of flypaper. The variation comes from whether the
estimated flypaper effect is simply large or if it is enormous” (Hines &
Thaler, 1995, p. 219). The flypaper effect may be attributable to the
way in which a local government frames federal grant receipts.
Rather than a choice between increased spending and decreased
taxes, governments may frame the decision in terms of how the
money should be spent (Hines & Thaler, 1995).
‘Leviathan’ governments seek to maximize their budgets rather
than maximize utility (Quigley and Rubinfeld, 1986). In maximizing
the budget, local governments may adopt federal priorities rather
than the priorities of the local median voter, leading to dependency
(Hedge 1983). Garand (1988) posits that flypaper effects are
responsible for increases in government growth as state governments
use federal grants to increase the level of public goods they provide.
Recent studies identify flypaper effects in specific policy areas, such
as transportation obligations (Gamkhar, 2000), education (Fisher &
Papke, 2000), and welfare (Volden, 1999). A study of federal aid
effects on county governments concludes the flypaper effect can only
be considered as a function of combined tax illusion and grant
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HALL
illusion (Mitias & Turnbull, 2001).
Outside the U.S., Slack (1980)
found intergovernmental transfers in Canadian government in 19745 increased municipal expenditures. The Indian federal system has
also seen flypaper effects resulting from unconditional
intergovernmental grants (Lalvani, 2002).
The alternative fungibility philosophy suggests that the flypaper
effect does not occur, and that recipients assimilate federal funds
into current revenues, reducing the cost of public services through a
reduction in local taxes. A dollar in tax revenue can be substituted by
a dollar of intergovernmental revenue. The use of federal funds as a
substitute for local revenues has led to federal program provisions to
prevent pure substitution, such as the ‘but for’ clause in the Urban
Development Action Grant [UDAG] program, “which stated that the
project would not be developed except for the presence of the UDAG”
(Watson, Heilman & Montjoy, 1994, p. 8)
Bradford and Oates (1971) theorized that lump-sum grants
should have allocative and distributive effects no different than if
these funds were distributed in a particular lump-sum pattern to the
residents of the locality. Fiscally hard-pressed jurisdictions that have
used grant funds to substitute for local revenue have suffered from
withdrawal of federal assistance (Nathan, 1983). Stein (1984) finds
that strong reliance on federal aid over time leads to treatment of
federal revenues as if they were locally generated own-source
revenue. Zampelli (1986) advocates stringent regulation of federal
grants to prevent fund reallocations, and to prevent fungibility from
limiting local implementation of federal priorities.
These two philosophies explain how federal grant money may be
incorporated into state/local budgets, and they are imperative to
understanding empirical assessments that seek to demonstrate
causality between federal funding and state budgetary reactions.
Conflicting empirical results in support of both flypaper and, to a
limited extent, fungibility, might suggest that the relationship is a
continuum rather than a dichotomy, where variations in local
conditions, federal restrictions and grant structure determine a given
grant effect’s position on the continuum. Bae and Feiock (2004) add
local government institutional characteristics as explanatory variables
in flypaper scholarship, finding flypaper effects more likely to occur in
cities with Mayor-Council forms of government than cities with a
Council-Manager structure.
The Mayor-Council form produces
THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
57
incentives for local leaders to maximize their budgets in Leviathan
tradition, whereas the Council-Manager form presents restrictions
that prevent departure from the median voter model through a
structure that separates those making policy (the council) from those
actuating policy (the manager).
Most studies that find evidence of the flypaper effect also
acknowledge that the increase in local spending is somewhat less
than the amount of the grant received. State/local governments
utilize a portion of grant proceeds to offset own-source expenditure (if
not elsewhere, as indirect costs). Even if some funds are used to
substitute for local revenue, flypaper can still exist if the increase in
local spending exceeds the increase that would occur from an equal
increase in local resident income.
Giving and Taking Away: Response to Decreasing Federal Aid
Debate continues over whether the flypaper response occurs in
reverse. Do reductions in federal aid lead to greater reductions in
local spending than an equivalent reduction in private income? The
response to falling federal aid can take one of three forms. First, a
reduction in federal aid can lead to reduction in state/local spending
by less than the reduction but more than from an equal reduction in
local resident income. This condition is a symmetrical response, or
flypaper in reverse. Two other conditions may occur under such
reductions, both of which are asymmetrical responses. A decrease in
federal funds may lead to no change in state or local government
spending, meaning the lower level government maintained spending
levels by replacing the lost federal revenue with local revenue through
increases in taxes or fees. This response is termed the fiscal
replacement asymmetry. Reduction in federal aid may also lead to
greater than expected reduction in local expenditures, meaning the
lower level government severely cuts spending—beyond the amount
of the grant funds—in light of the federal cuts (Gamkhar & Oates,
1996).
This response is termed fiscal restraint or fiscal
retrenchment. Nathan and Doolittle (1985) and Gamkhar (2000),
find different results under different conditions. Nathan and Doolittle
(1985) find that symmetry was the status quo, but communities that
were more favorable to spending (liberal) and had stronger fiscal
health replaced federal funds with own source revenues. Gamkhar’s
(2000) study of federal transportation obligations—the precursor to
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the grants and the basis of state spending decisions—uses a lagged
measure to match funding activities with the longer lifespan of
construction projects in the transportation field. This study revealed
evidence of all three responses for different timeframes. In the
current year, reductions in federal aid led to greater than expected
spending cuts—evidence of fiscal restraint. In one and two-year
lagged measures; on the other hand, the state spending response
was symmetrical. The three years combined revealed that spending
cuts led to fiscal replacement of federal revenues with own-source
revenues by the states. The timeframe for completion of construction
projects explains these results; in the case of lagged variables, the
construction projects may be near completion, and the sunk costs of
nearly completed projects are greater than those of projects in
planning or design phases.
Several studies find evidence that flypaper effects are
symmetrical between federal grant increases and decreases
(Gamkhar & Oates, 1996; Stine, 1994; Nathan & Doolittle, 1985).
Empirical analysis strongly favor the symmetric effects hypothesis:
“State and local spending rises an average of 47 cents for each
additional dollar of non-matching grants. When non-matching grants
fall,…the expenditure response of state and local government is
roughly similar in magnitude to their response to an increase in such
monies” (Gamkhar & Oates, 1996, p. 509). Matching grants
demonstrate a much larger stimulative effect on spending than nonmatching grants, but still with no evidence of asymmetry (Gamkhar &
Oates, 1996).
Numerous studies find fiscal replacement asymmetry in response
to federal grant reductions (Holcombe & Stroup, 1996; Hedge, 1983;
Volden, 1999; Lalvani, 2002; Stein, 1984). Once spending has
increased it is difficult to reduce it again (Holcombe & Stroup. 1996).
Hedge (1983) finds dependence led West Virginia state agencies to
pursue budget allocations from own-source revenue through lobbying
and larger budget requests. Declining federal aid for AFDC resulted
in fiscal replacement, a change also attributed to the burgeoning
bureaucracy and its ability to argue for funding increases (Volden,
1999).
Stein (1984, p. 641) observes, “If, as has occurred under the
Reagan administration, aid is severely reduced, city officials are left
with a significant revenue gap and the potential for fiscal and political
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THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
59
insolvency.” Once federal aid has increased the workforce, subnational governments face a choice to reduce employment, or to
raise own-source revenues to close the gap left by declining federal
grant funding. Little empirical evidence supports the notion that
states cut spending in response to declines in federal aid. Only
Gamkhar (2000) found evidence of retrenchment in one specification
of the model.
Any reduction in spending, whether symmetrical to or greater than
the flypaper effect (retrenchment), will result in a reduction of
government efforts in that policy area. This would lead to reduced
public services, and where services are to be reduced, tough political
questions. Who will lose benefits? Will benefits be equally reduced?
Which program should be cut? If the program was predominantly
funded through federal grants, the decision to maintain that service
may lead to reductions in other state/local programs to finance the
activity. Alternatively, fiscal replacement will result in maintained
service levels or increases in services, but at the cost of increased
taxes on local residents and businesses. Over time, the illusion of
price and income may disappear, and the cost of the services borne
by the local constituents will become more obvious.
Long-Term Effects: Federal Aid Dependency and Withdrawal
Dependency is widely recognized in the literature (Hedge, 1983;
Stein, 1981; Stein, 1984), with differences state/local government
reactions to perceived dependency. Some fear that any recipient
government will become dependent upon federal funds if exposed to
a stream of federal funding over the long term (Stein, 1981). Others
fear governments may avoid federal funding altogether for fear of
becoming dependent, or that they may only use federal funds for onetime expenditures such as capital projects (see Nathan, 1983).
Grant characteristics may have a great deal to do with whether or
not states/localities become dependent on federal funding.
Consequently, a state’s reluctance to become dependent may lead it
to seek only project grants, missing opportunities that may result
from discretionary revenue. Federal grants may have varied effects
on recipient governments because those governments differ in
political environment (the way they perceive the federal grants) and
fiscal condition (their ability to raise local revenues or their need for
outside assistance) (Nathan & Doolittle, 1985; Stein, 1984).
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Localities that suffer from declining population, minimal resources, or
excessive poverty are more likely to become dependent on federal
grant funding.
Different governments react differently to the
opportunities with which they are presented.
Nathan (1983)
alternatively suggests that dependency has nothing to do with what
type of grants a government receives, over what period of time, or
with relative local discretion in spending. Rather, he posits that the
difference is in how the government treats the funds it receives—are
they treated as general revenue, or are they maintained in a separate
budget category so as not to affect local services in inconceivable
ways? (Nathan, 1983). This may prove to be a strong predictive
factor in determining the effects that cuts in federal aid have on the
states and local governments.
Governments’ response to changing levels of federal grants has
recently been examined in the combined context of spending and
public debt held by the states. State long term debt issuance effects
are asymmetrical between increases and decreases in grants (Martell
& Smith, 2004). The response is different, however, for different
types of debt; full faith and credit debt is positively related to both
matching and nonmatching grants, and the asymmetric response in
periods of declining federal grants is characterized as fiscal
replacement. That is, states tend to take on debt to replace
decreasing federal funds. On the other hand, non-guaranteed debt
issuance is negatively related to both matching and nonmatching
grants, and the asymmetric response is characterized as fiscal
restraint. When federal money declines, states tend not to replace it
with non-guaranteed debt issuance.
Because federal grants vary in their inherent expectations of and
restrictions on sub-national governments,it is necessary to consider
the likelihood that different types of grants may have different effects
on state and local governments. Differences between block grants
and categorical project grants, for example, may have implications for
the way governments incorporate federal funding. Unconditional
grant types, such as revenue sharing, previously, and block grants,
presently, have fewer strings attached, and may be more likely to fall
subject to substitution (fungibility) rather than supplementation
(flypaper). Conditional grants, including project and categorical
grants and matching grants tend to generate larger flypaper effects,
whereas unconditional grants do so to a lesser degree. Conditional
Deleted: ,
Deleted: ,
Deleted:
THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
61
grants should not foster dependency, whereas block grants or other
unconditional funds may lead to long-term dependency on the federal
government.
CHANGING GRANT STRUCTURES IN COMMUNITY DEVELOPMENT: POLICY
AND PRACTICE
The theoretical and empirical studies detailed above seek to
improve our understanding of the aggregate effects of federal grants
on state and local governments; over time, these studies have
become more and more specific, with some focusing on local
government (Stine, 1994), and with some focusing on particular
policy areas such as transportation (Gamkhar, 2000) or education
(Fisher & Papke, 2000). This section applies the existing literature to
recent fiscal and political trends in the community development policy
arena. The effects of grant types and structures on state/local
budgetary responses, and state/local budgetary responses to
reductions in federal funding provide fodder for discussion.
Although federal spending in many policy areas (defense, for
example) is increasing, there have been recent attempts to reverse
that trend for community economic development, such as the
Strengthening America’s Communities Initiative (SACI). President
Bush’s proposal would have cut the total amount of available federal
funds for community development from $5.31 Billion in FY 2005 to
$3.71 Billion in FY 2006 (U.S. Department of Commerce, 2005).
It is equally important that the suggested community
development funding cuts were intended to be implemented through
structural changes to the existing grant apparatus by consolidating
eighteen existing grant programs, many of which are categorical or
project grants, into a single block grant under the Strengthening
America’s Communities Initiative (SACI).1 While most of the affected
programs were project grants, the bulk of funding the proposal would
have been drawn from the CDBG entitlement program—a formula
grant (See Table 1). This structural change mirrors President
Reagan’s effort in the early 1980s to devolve decision making
authority back to the states by providing programs with fewer strings
attached while reducing total federal spending. The action would
have moved programs from five federal agencies into the U.S.
Department of Commerce under one new block grant with incentive
Deleted: the
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HALL
TABLE 1
Composition of Structure and Matching Requirements for Grant
Programs Proposed to be Consolidated into SACI, by Agency
Agency
HUD
Program Name
CFDA #
Grant Type
Match Requirements
14.218
14.219
Formula
Formula
None noted
None noted
CDBG Set asides
NCDI
BEDI
RHEC
UEZ
CDLS
14.227
14.246
14.25
14.244
14.248
Project
Project
Project
Project
Loans
None noted
Used in conj w/ loan
None noted
None noted
None noted
RBEG
RBOG
EIG
REZEC
10.769
10.773
n/a
10.772
Alloc/Proj*
Project
90% Formula
Project
None noted
None noted
n/a
None noted
CDFI
BEA
CDFNI
21.02
21.021
21.02
Project
Project
Project
1 to 1
None Noted
1 to 1
CSBG
93.569
93.57
n/a
n/a
Formula
Project
Project
Project
None
None
n/a
n/a
11.302
11.303
11.3
11.307
11.312
11.313
Project
Project
Project
Project
Project
Project
1 to 1
1 to 1
1 to 1
1 to 1
Waived
1 to 1
CDBG
USDA
Treasury
HHS
CED
RCF
Commerce
EDA
payments to communities that meet requirements (U.S. Dept. of
Commerce, 2005). As noted in the previous discussion, block grant
structures typically devolve discretion over spending to the states by
reducing the number of strings attached and by broadening the
eligible category of spending. The more flexible the resources, the
more fungible they become, and the more likely local governments
will become dependent on federal funding. This concurs with the
stated goals of the SACI proposal: increasing communities’ “wide-
THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
63
ranging” flexibility in the use of federal funds (U.S. Dept of Commerce,
2005, p. 12).
What are the implications for state/local governments as a result
of the combined structural and funding changes that have been
proposed? In the short term, the most obvious effect would be
reduced federal funding for traditional community development
activities by about 30 percent. According to the SACI proposal
overview (U.S. Dept. of Commerce, 2005) most current recipients
would remain eligible for funding, but an emphasis on targeting would
result in fewer, larger awards to the neediest applicants. What
reaction would state/local governments have if the proposal were
approved? The change would create winners and losers, with some
communities facing reduced federal aid while others would be seeing
increased federal funds.
Governments might deal with the change through some
combination of increased taxes or debt (fiscal replacement), or with
cuts to community development spending (fiscal restraint), or might
trim budgets to reduce total spending while maintaining some
community development spending. If funds are cut as SACI
proposed, future analysis would very likely show that governments
have grown dependent on entitlement funding but not on project
grant receipts. It is noteworthy that the SACI proposal called to
replace numerous project grant programs with unified block grant
funding. Thus, a second question is: how would communities react to
the new grant?
Returning greater flexibility and decreasing
restrictions on use of federal funds would advance the
administration’s goal of returning discretion to local government, but
it also poses the threat of new dependency on federal government
aid. (This effect would be mitigated somewhat by the reduced number
of awards and increased targeting SACI proposed.)
Institutional structure is expected to be an important determinant
of local government response to changes such as those proposed by
SACI as well. Unreformed governments lack diversity in strategy for
economic development, particularly in areas of greatest need (Feiock
& Cable, 1992), and they are more likely to demonstrate flypaper
effect in response to intergovernmental aid (Bae & Feiock, 2004).
Thus, local governments with greater need and Mayor-Council
structures of governance are most likely to be dependent on federal
aid. Reform charter governments (Council-Manager) may mitigate the
64
HALL
negative effects of reduced but less-restricted federal aid for
development. This does not imply that Mayor-Council governments
should amend their charters in anticipation of federal aid reductions;
rather, they should be cognizant of potential dependency in their
approach to federal grants.
How might state/local governments react to increased discretion
afforded by a new block grant structure? Match requirements vary
considerably among current programs that were proposed for
consolidation into SACI. For example, the HUD programs typically lack
matching requirements; while programs under the Economic
Development Administration fund only fifty percent of total project
costs (see Table 1). So, while programmatic changes increase
flexibility, eliminating match requirements from some programs would
also advance that purpose. Increased flexibility and discretion may
make payments more fungible, such that over time dependency may
increase, or federal funds are used to replace local revenues to
maintain spending.
Traditionally, block grant structures have
deferred discretion to state/local governments resulting in more local
flexibility.
If federal funds for community economic development in years
past increased local spending, state/local reductions in response to
reduced federal aid would be of particular interest. Symmetrical or
fiscal retrenchment reductions could cause communities to face a
number of pitfalls. For example, fiscal retrenchment in times of
decreased federal funds may mean decreased program offerings or
poor program outcomes. Fiscal replacement would mean increased
local debt burden or taxes.
Amid spending cuts, leaders must make tough decisions; first,
whether to continue programs or to cut programs, and if the former,
whether to seek alternate own-source funding or to stretch existing
local dollars to their maximum potential. As history repeats itself,
federal programs will be added and altered; as power changes hands,
pressures will likely emphasize categorical grants at some point in the
future, and spending may increase. Local governments should be
wary of the potential effects of shifts between block grant and project
grant structures as they plan for and utilize federal revenues.
Whether under the existing programs or under some new composite
program like the proposed SACI, grant characteristics and local
Deleted: ,
THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
65
characteristics coalesce to determine the effects grants will have on
long-term local viability and community development success.
SACI failed in FY 2006; Congress broadly rejected the proposed
initiative, demonstrated by the following excerpt from S. Rept. 109109 (U.S. Senate, 2005, p. 153):
The administration has proposed to eliminate the Community
Development Block Grant [CDBG] program by consolidating
CDBG activities, and most of the set-asides within the
Community Development Fund, into a new economic
development block grant… Under the proposal, some 18
programs, including CDBG, HUD Brownfields program, and the
Rural Housing and Economic Development program, would be
terminated and/or merged into the new block grant. Proposed
funding for all these programs would total $3,700,000,000
instead of the overall $5,640,000,000 which funded these
programs in fiscal year 2005. This represents a reduction of
$1,940,000,000 or 34.2 percent from fiscal year 2005
levels…The Committee has rejected the entire proposal since
it would undermine HUD's mission and essentially strip HUD's
scope of activities to almost only housing programs.
Local governments can rest easier with the knowledge that Congress
rejected SACI in 2006, but there is evidence that many agree with the
proposal’s merit; assuming it will not appear in future budgets is
naïve.
To illustrate, Senate Appropriations Committee
recommendations generally restored funding to FY 2005 levels, but
the House Appropriations Committee followed the administration’s
recommendation to zero-out some program budgets (such as
Community Development Loan Guarantee Program) and
recommended reducing CDBG funding by $250,000,000 (U.S.
Senate, 2005; U.S. House of Representatives, 2005).
CONCLUSION AND DISCUSSION
Studies investigating the effects of federal grants on state/local
budgets have not been conclusive. In spite of some disagreement,
the broad consensus among fiscal federalism scholars is that federal
grants do induce local governments to increase their spending by
more than if they had an equal increase in local resident income.
Studies that confirm the flypaper effect find that local spending
66
HALL
increases by an amount less than the grant amount, with variation in
the actual amount. Matching or conditional grants induce a greater
spending response than unconditional or non-matching grants.
These findings suggests need for improved specification of the
variables in question to better understand the relationship of grant
types and local government characteristics, such as tax base, in
determining the local government response.
Federal grants lead state and local governments to increase
spending by altering the perceived price of services. Unconditional
grant receipts are more likely to be substituted for own-source
revenue in state/local budgets, leading to a lower spending increase
than would result from a conditional grant. It follows that project or
categorical grants and matching grants (conditional grants) are more
subject to the flypaper phenomenon, and should demonstrate higher
local government spending than their unconditional counterparts.
Flypaper is observed in both cases, but to a greater extent in the case
of conditional grants than entitlement grants.
Over time, local governments may become dependent on streams
of federal revenue, which may weaken their fiscal footing in times of
federal cutbacks. Fiscally weak jurisdictions have been shown to be
more susceptible to dependency on federal aid. Dependency may
relate closely to the type of grant the state is receiving; block grants
afford more local discretion and less federal restriction, and more
easily substitute for local revenue, while project or categorical grants
have much greater federal control, and tend to be spent for their
intended purpose. Nonrestrictive funds may foster dependency over
time, leading governments to seek conditional grants to support their
spending habits.
Relatively little empirical analysis has examined the changes that
take place in state/local budgets in response to reductions in federal
intergovernmental transfers, such as the significant cuts early in the
first Reagan administration. These studies have been inconclusive
and most do not provide analysis to assess whether symmetrical or
asymmetrical responses by local governments to federal grant
reductions are the norm. (The exceptions are Gamkhar [2000], Stine
[1994], and Gamkhar & Oates [1996]). Theory provides a basis for
examining changes that have occurred in the recent past; however,
the scope and aggregation problems within these studies limit their
generalizability across time and location.
THE CHANGING FEDERAL GRANT STRUCTURE AND ITS POTENTIAL EFFECTS
67
Three state/local government responses to reductions in federal
aid are possible; first, reduced federal funding may be mirrored by a
spending reduction equivalent to the increase triggered by the grant
(symmetry); second, reduced federal funding may be met with a
greater reduction in local government spending (fiscal restraint, or
fiscal retrenchment asymmetry); and third, reduced federal funding
may be met with no significant reduction in state and local spending
(fiscal replacement asymmetry). As in the case of flypaper effect,
some evidence of each of these effects has been shown by empirical
analysis (Gamkhar, 2000). Although evidence of each response has
been found, the conditions under which each response is likely to
occur remain unknown.
State and local governments are not always distinguished in this
literature, as both are recipients of federal aid, and as both are
subject to the potential ramifications of federal aid with which we are
concerned. They are, however, not equivalent. The matter of scale is
relevant, as a federal grant typically constitutes a larger portion of
local, than state, budgets. Local tax bases are not as broad, nor
taxing capacities as great, as the states’, so federal cuts can not be
absorbed by local governments as easily as they can at the state
level. Furthermore, local governments may also receive additional
assistance through state programs that can supplement or offset
federal aid reductions; states have no further recourse. While current
knowledge rests on a few studies that often consider state/local
governments as equals, future empirical work must clarify these
important distinctions to ensure more generalizable results.
Future analysis will benefit from considering effects within policy
areas in which numerous governments of different types are
impacted.
The 2006 SACI proposal provides impetus to be
concerned about the effects of federal grants on local governments in
the context of community economic development. Policy makers and
administrators must be aware of the effects federal grants may have
and structure decisions about whether to seek, and how to treat,
federal aid around local conditions and preferences. Rather than
focusing on the promise of greater flexibility, attention to potential
pitfalls will lead to better decision making. Federal policymakers
have long used grants-in-aid to persuade state and local governments
to pursue federal policy agendas; sub-national governments must not
68
HALL
blindly expect the federal government to look out for their best
interests.
ACKNOWLEDGEMENTS
I wish to thank Ed Jennings, David Freshwater, Merl Hackbart,
David Wildasin, Rick Maurer, Donna Handley, and numerous
individuals at the Southern Political Science Association for their
helpful comments on earlier drafts of this manuscript.
NOTES
1. Although the proposal overview states that eighteen programs
would be consolidated, the actual proposal reveals a broader
consolidation. For example, the overview counts EDA as one
distinct program, while in fact it encompasses six existing project
grant programs.
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