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The following OECD assessment and recommendations summarise Chapter 3 of the Economic Survey of the United States 2005 published on 27 October 2005.
Is there room for improving relations between different levels of government?
In a country as economically and demographically diverse as the United States, the large degree of fiscal autonomy of the states and, to a lesser extent, local governments is appropriate. There is considerable variation in the scope and amount of government services provided, likely reflecting some degree of heterogeneity in local preferences. Indeed, there is some evidence that the provision of public goods and services at the local level is quite efficiently aligned with local tastes. While there are areas – notably education, welfare and public health – where externalities require involvement by higher levels of government in the form of grants and, within states, some revenue redistribution, such redistribution is weak for the most part, in particular across states. This implies a comparatively close link between revenue raising power and expenditure assignments, with attendant gains in accountability of each layer of government. Although fiscal relations across levels of government are thus producing positive outcomes overall, there is scope for improvement.
Grants from the federal to state governments are not primarily motivated by redistribution concerns. Some are matching grants and hence seem to reflect efficiency considerations. However, matching rates often appear excessively high. Conversely, the recent expansion of earmarked block grants, notably in the welfare area, suggests that correcting spill over effects is not always the dominant motive. In the light of the experience with state experimentation in the design of welfare programmes, greater authority for programme design and responsibility for financing in several areas should be given to the states; tendencies to restrict state flexibility through overly onerous conditions should be resisted. In particular:
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When renewing funding for Temporary Aid for Needy Families (TANF), states’ ability to tailor programmes to their local needs should not be impeded by tightening work requirements in ways that prove impractical to implement.
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Given that a nation-wide highway network has been established, responsibility for highway funding should be turned over to the states, together with the right to charge tolls, and the federal highway trust fund should be dissolved.
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The costs of implementing the No Child Left Behind Act need to be more precisely quantified and adequate federal funding ensured.
The Medicaid programme is probably an exception to this trend of devolution. Its rate of expenditure growth is such that states would not be able to assume greater responsibility for financing the programme in view of their limited ability to raise revenues. Hence, a shift of all Medicaid expenditures for the elderly and disabled to Medicare should be considered, as it would concentrate responses to the nation wide challenge of ageing at the federal level. Federal matching rates for the remaining Medicaid services could then be reduced. In any case, the states should curtail their improper use of intergovernmental transfers so as to strengthen the integrity of Medicaid financing.
States’ autonomy over their taxation decisions in principle provides a high degree of independence on the expenditure side. However, it is constrained by taxpayer mobility, which limits the progressivity of the personal income tax and the potential yield of corporate income tax, and by states’ inability to collect use (sales) tax on remote sales. To improve the efficiency of their revenue systems:
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States’ efforts to co ordinate sales tax policies through the adoption of joint definitions and rules of tax administration are worthwhile and should therefore be continued; assuming successful implementation of the Streamlined Sales and Use Tax Agreement, Congress should authorise them to require remote vendors to collect use tax on their behalf.
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In view of the high administrative costs of the corporate income tax and the continued erosion of its base, as well as the inherent inefficiencies of the sales tax, states should consider replacing both taxes by a value added tax (VAT), preferably jointly with the federal government. The experience with the Streamlined Sales Tax Project to co ordinate the administration of the sales tax and facilitate information exchange might prove helpful to structure a VAT based on the destination principle.
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As previously noted, the deductibility of state and local taxes from federal income tax should be abolished, as it raises the burden of the latter by narrowing its base, thereby requiring higher rates, while at the same time it appears to distort state and local governments’ financing and spending decisions.
The balanced-budget requirements under which almost all states operate appear on the whole to have effectively disciplined state fiscal policies, but there is some risk that this discipline may have been achieved at the cost of undesirable volatility in core service provision. The additional tax and expenditure limitations applying to many state and local governments are intended to impose even stricter discipline, but they are also more likely to cause undesired cyclical patterns of state and local spending and to erode local governments’ fiscal autonomy. Fiscal rules at the sub-national level might benefit from the following changes:
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Based on the experience during the recent fiscal crisis, the states should quantify and accumulate rainy day funds of sufficient size to avoid welfare reducing cuts in core expenditures, except under extreme circumstances. Those states that have statutory caps on rainy day funds should adjust them if necessary.
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Tax and expenditure limitations should be formulated in reference to desired spending levels, not by limiting the growth in revenues or expenditures to recent realised values of state income growth or similar characteristics, so as to account for changes in demand for public services due to demographic changes and to avoid ratchet effects in the aftermath of recessions.
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Return to the Economic Survey of the United States 2005
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For further information please contact the United States Desk at the OECD Economics Department at webmaster@oecd.org. The OECD Secretariat's report was prepared by Hannes Suppanz and Thomas Laubach under the supervision of Peter Jarrett.
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