Let’s Return Real Fiscal Authority to the States

By Dr. Dwight Lee

[Editor’s Note: This speech was presented at the 1995 Georgia Tax and Budget Conference on April 5, 1995.]

It’s a pleasure to be here at the Georgia Tax and Budget Conference. I want to thank the Tax Foundation and the Georgia Public Policy Foundation for inviting me to participate.

I’ve been asked to give a wrap-up of the conference and to talk about the road ahead. Although much of the discussion at this conference has been on taxes and spending at the state level, I would like to shift the emphasis a little bit by arguing that one cannot fully grasp what’s happening at the state level regarding taxes and spending unless one first considers the fiscal relationship between states and the federal government.

If you are interested in the long-term growth of the state’s economy, the best thing to do is to keep taxes as low as possible. There is a lot of evidence to support this proposition. Unfortunately, the fiscal relationship between states and the federal government works against this type of fiscal responsibility and farsightedness. In fact, it makes it very difficult for local politicians to take the long-run view when considering tax policy.

The overriding reality today is that much of a state’s tax base goes directly to Washington. States then have to plead and struggle to get some of that revenue back. This creates a situation where it is almost impossible for state politicians to act responsibly. I’ll explain.

Most of us want our state officials to go to Washington and get back as much of our money as possible, because we know that if we don’t get it back, the federal government will not say, “Well, Georgia didn’t get much money back, so we’ll quit taking as much money from them.” We are going to keep sending most of our taxes to Washington regardless of how much we get back.

The result of this process is that any cockamamie project looks pretty good to state politicians, provided it will appeal to federal officials and will result in the recapture of some tax dollars. For example, if federal officials become enamored with the buzzword “empowerment,” then we’re going to come up with funding proposals . . . and call them something like “empowerment zones.” What we’re really doing is begging. We’re begging . . . “please give us some of our money back.” But our begging is now called “empowerment.”

Does anyone really believe that changing the name of “urban renewal” to “empowerment zones” is going to change thirty years of failure into a big success? I don’t think anyone really believes that, but they still might vote against a politician who refuses to go to Washington to beg for Georgia. Most people believe that, since somebody else is going to be wasting the money anyway, we would rather waste it right here in Georgia!

You might think that, with all of this federal money coming back to Georgia, we could lower state and local taxes. However, it’s not clear at all that this process lowers the taxes we pay right here in the state. First of all, it costs a lot of money to beg for our money back. The state government is full of agencies that are designed to go to Washington and lobby for our money back. And, of course, the federal money always comes back with red tape that requires state bureaucracies to be bigger and more expensive than they otherwise would be. It’s not too much of an exaggeration to describe this as a situation where we’re all paying tribute to Washington for the privilege of stealing from each other!

Another way of looking at the existing fiscal arrangements between states and the federal government is to see it as a big tax cartel. In the early 1900’s, the federal government took about 2 or 3 percent of the total GNP. Now it’s 25 percent. Until the 1930’s, most of the taxes in this country were paid at the state or local level. The federal government got a very small share. When most of the tax money was paid at the state and local level, there was a lot of tax competition between the states. People could punish high-tax, low-service states by simply moving — voting with their feet, just like customers do. That imposed fiscal discipline.

Beginning in the 1930’s, the federal government began usurping more and more of the taxing authority, which reduced the tax competition among states because it didn’t make much difference whether you were in Georgia or Alabama or Mississippi or New York or Utah or California — you were going to pay that federal tax anyway. A person couldn’t escape the tax, short of leaving the country, so tax rates were increasingly set monopolistically at the federal level rather than competitively at the state and local levels. And as you might expect, when the federal government took control, the overall tax burden went up dramatically.

There has been a lot of discussion lately about devolution — shifting functions back to the state and local levels. But I predict that nothing is going to come of it unless we first shift the authority and responsibility to tax back to the state and local levels. As long as the primary taxing authority is in the hands of the federal government, we will never have anything more than the pretense of state and local authority.

Let me give an example. There’s been a lot of discussion of the flat rate tax. Many people support it, but there is a problem. Let me explain why. Economists — and I’m an economist — have always said that the flat rate is the best tax because it’s less distorting. Lower the rate — those high marginal rates that are strong disincentives for productive activity — and close the loopholes. That way, people will stop making economic decisions on the basis of where they can get the biggest tax break, and will start making economic decisions on where they produce the most wealth. That’s the advantage of the flat rate tax. I like that, but now the problem.

The flat rate tax, by closing the loopholes, makes it easier for government to get more of our money. So I would argue that we need to flatten the power of the federal government to tax rather than giving it a flat rate tax. I like a flat tax — but at the state level — not the federal level. The State of Georgia has a flat rate tax that makes sense because distortions are eliminated, and yet tax competition among the states keeps Georgia from using the power to tax as a money machine.

Let me conclude by making another forecast. I’ve been asked to talk about the road ahead, so I’ll turn briefly to that. I would forecast that merely tinkering with the state tax structure won’t ultimately make much of a difference . . . not as long as most of our tax dollars go to Washington. What we should do is work on some really bold, innovative proposals that will likely be dismissed as impractical, but might, down the road, have a chance to do a lot of good.

I recommend that we eliminate the power to tax by the federal government entirely. All the power to tax would reside at the state and local levels. That was the concept of the Articles of Confederation. But there was a problem with the Articles of Confederation — the states didn’t give the federal government much, if any, of the money they raised. My proposal, however, would require states to pass along to the federal government, say, 25 percent of every dollar raised. There are many advantages to this. The federal government has several important functions to play. One is obviously national defense. The federal government does not have an important function fixing potholes in Peoria or paying for midnight basketball in Atlanta, or building bike paths in Baltimore. There’s a whole host of things that the federal government does that, if worth doing, would be done by the states. Under my proposal, the federal government wouldn’t do those things anymore. The federal government would no longer spend its limited money on state and local projects because doing so would reduce the need for state governments to raise taxes. This would, in turn, undermine the federal government’s only source of revenue. Also, we would soon find state governments privatizing like crazy because the real payoff would be in efficiency, not inefficiency, as is now the case.

That’s my impossible dream. We can’t move to that right now, but there are things we can do, like term limits, that will help get us there. Get some people in Washington who haven’t been there long enough to actually believe that western civilization depends on federal spending programs.

A balanced budget amendment is also something we could do now. We must start tying the hands of the federal government. If we don’t do that, much of this discussion — of what we should do at the state and local level — is simply going to be wasted effort. I’m not against interim reforms, but it’s just not going to be as successful as returning real fiscal authority to the state and local level.

Dr. Dwight Lee is the Ramsey Professor of Economics at the University of Georgia and a member of the Georgia Public Policy Foundation’s Academic Advisory Board. The Georgia Public Policy Foundation is an independent, non-partisan organization dedicated to keeping all Georgians informed about their government and to providing practical ideas on key public policy issues. The Foundation believes in and actively supports private enterprise, limited government and personal responsibility.

Nothing written here is to be construed as an attempt to aid or hinder the passage of any bill before the U.S. Congress or the Georgia General Assembly.

© Georgia Public Policy Foundation (November 3, 1995) Permission is hereby given to reprint this article, with appropriate credit given.