Stimulating $19,000,000,000 in New State Taxes

Among the proposals the president is considering in his latest round of stimulus is an additional $50 billion in transportation spending. It is not clear, but near as I can tell from reading the reports, the money would be channeled through the states. Now, one might think that federal lump-sum grants to state governments would offset the states’ own expenditures, allowing them to cut their own taxes. In fact, according to new research, a $50 billion grant to state governments is likely to cause them to raise their own taxes by about $19 billion.

A well-documented phenomenon known as the “flypaper effect” has found that when the federal government makes grants to state governments, the latter do not decrease their own expenditures by anywhere close to the level of the grant. The idea is that the money sticks where it lands; hence the funny-sounding name. Now, new research by the University of West Virginia University’s Russell Sobel and George Crowley shows that it is even worse than previously thought. 

Prior studies had focused on state spending reactions in the year in which grants were made. But Sobel and Crowley’s research (based on data from 50 states over a 13 year period) finds that even after the federal money goes away, state and local governments tend to permanently increase their own spending and taxation in order to keep the newly-funded programs running. (If this argument sounds familiar, it is because Governor Sanford actually made it back when the last stimulus was passed).

What is the magnitude? For every $1.00 in federal grants that a state receives today, the state can be expected to increase its own future taxes by somewhere between $0.33 and $0.42 in the future. Let’s assume it is the average of this range and that future state taxes will rise by $0.38 for every $1.00 in federal aid. If this is the case, then an additional $50 billion in “aid” to the states will cause states to raise their own future taxes by about $19 billion.