Key Takeaways

  • A rich state can potentially raise more tax revenue than a poor state (its fiscal capacity), and therefore provide superior public goods at more attractive tax rates. Diverse countries like the United States attempt to adjust for subnational variation in fiscal capacity through inter-governmental grants, i.e. fiscal transfers to poorer states. 
  • In practice, the American system of federal grants is regressive, providing windfalls to rich states while squeezing budget-strapped poor states. This creates a perverse dynamic that perpetuates regional inequality and economic divergence.
  • Criticisms of poor states as “low tax, low service” are fundamentally mistaken. In general, poor states exert similar fiscal effort as rich states, but generate a fraction of the revenue for education and social assistance due to the simple fact that they’re poor.
  • Well-designed grants ensure horizontal equity, enable minimum standards, and help avoid poverty traps. Applying these principles, this paper proposes budget neutral but distributionally-progressive reforms to Title I education grants, Medicaid matching grants, and the TANF block grant—each designed to help fix our broken fiscal union.

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