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Fiscal Federalism

Last Updated: 2018

Fiscal federalism is an economic framework for understanding the relationship among federal, state, and local governments that focuses on the division of spending and taxing powers among these governments.

Fiscal federalism is primarily an economic, rather than political, theory of relationships among central and noncentral governments. One focus is the division of responsibilities among different types of governments. For example, the traditional theory of fiscal federalism argues that the central government should be responsible for macroeconomic policies but local governments should be primarily responsible for fire protection services. Another focus of fiscal federalism is the division of revenue-raising powers among various governments, often referred to as “tax assignment.” Here the traditional theory of fiscal federalism argues that taxes on highly mobile entities should be assigned to the central government, and taxes on less mobile entities to state or local governments. Finally, grants-in-aid become an important topic in fiscal federalism because of the potential mismatch between a government’s expenditure responsibilities and its tax capacity.

The traditional theory of fiscal federalism sets out principles regarding the proper division of spending responsibilities and taxing powers among types of governments. However, the term “fiscal federalism” is often used in a broader sense that includes a description of the actual division of spending and taxing powers.

Economists often use the term “fiscal federalism” to refer to one part of the field of public finance. Public finance is the economics of government spending and taxation, and when more than one type of government is involved economists apply the label of “fiscal federalism.”

There are some differences between fiscal federalism and political theories of federalism. Fiscal federalism applies to any country with both central and decentralized governments, as long as the decentralized governments have some control over spending and taxing policies. This control does not have to be substantial or constitutionally based. Thus fiscal federalism applies to many countries that political scientists would categorize as unitary rather than federal. When applied to the United States, fiscal federalism typically includes local governments in addition to the federal government and state governments. In the fiscal federalism framework, the fact that local government powers are not constitutionally independent is irrelevant.

Traditional fiscal federalism ignores politics, political institutions, and political power. Fiscal federalism must also be distinguished from a second economic theory of federalism, competitive federalism. Competitive federalism focuses on competition among governments, another subject area ignored in traditional fiscal federalism.

In recent years a new literature on fiscal federalism has emerged that considers the performance and evolution of federal systems, taking into account such issues as principal-agent problems, economics of information, and the theory of contracts (Oates 2005, Weingast 2009). Researchers refer to this evolving literature as a second generation theory of fiscal federalism and the traditional fiscal federalism as first generation fiscal federalism. This essay concentrates on first generation or traditional fiscal federalism, hereinafter referred to simply as fiscal federalism. Although the theory of fiscal federalism applies to many countries across the world, the tables below all describe the U.S. federal system, which is unique among federal countries, in part because of its tremendous diversity among the fifty states (Boadway and Shah 2009, Garcia-Milà, McGuire, and Oates 2017).


Government expenditure responsibilities can be divided into stabilization, distribution, and allocation functions. Fiscal federalism provides general guidelines for dividing these responsibilities among federal, state, and local governments based on the nature of the expenditure function and the relative capabilities of the different types of governments.

The stabilization function entails efforts to impact unemployment and inflation levels and stimulate economic growth. Stabilization tools include fiscal and monetary policies. As no state or local government is big enough to affect the overall level of economic activity, experts agree for the most part that the stabilization function is best left to the federal government.

The distribution function concerns use of government’s powers of spending and taxation to redistribute income, in particular by providing assistance to poor households. Experts agree that this function is usually best left to the federal government. State or local efforts to redistribute income can be rendered ineffective because of the small geographic reach of these governments and their mobile populations. For example, efforts to redistribute income from high-income to low-income households could lead to a counterproductive out-migration of high-income households and in-migration of low-income households.

The allocation function concerns the production or provision of goods and services, such as national defense, university education, or garbage collection. Whether these functions should be provided by federal, state, or local governments depends upon a number of factors. First, the geographic reach of service benefits must be considered. As the benefits of national defense are national in scope, this service is best left to the federal government. In contrast, the impact of fire protection is local, and can often be best provided by local governments.

Economies of scale (per unit costs of production fall as the scale of production rises) and externalities or spillovers (whereby activities undertaken in one geographic area impact citizens in another area) are factors that tend to make government goods and services best provided by larger units of government such as the federal government or state governments.

TABLE 1. Percentage of Expenditures on Selected Functions by Type of Government, 2015

Federal (%)State (%)Local (%)Total (%)
Health and Hospitals80911100
Public Welfare45505100
Social Security10000100

Sources: Budget of the U.S. Government FY2017 and U.S. Census.

Diversity in demand is the most important factor favoring local government provision of government goods and services. Local governments can best tailor services to fit the needs of their citizens. Decentralized provision of government services also facilitates a natural laboratory in which innovations tried and proved successful by one government can be adopted by an entire state or the federal government.

For the most part, the division of expenditure responsibilities in the U.S. federal system follows the pattern suggested in the traditional theory of fiscal federalism. Thus, the federal government provides national defense, state governments provide highways and university education, and local governments provide police and fire protection and K–12 schools.

However, there are some anomalies, such as the large nonfederal role in public welfare, largely a distribution function. In addition, there is some overlap of responsibilities, as in the provision of K–12 education in which state governments and the federal government have been playing an increasing role. Periodically, calls are made to change the division of expenditure responsibilities. Thus, Alice Rivlin (1992), a prominent economist and policy analyst, suggested the federal government eliminate most of its programs in education, housing, highways, social services, economic development, and job training, instead focusing on international issues and taking over full responsibility for health care financing, which it now shares with states in the Medicaid program.


Once expenditure responsibilities are divided among federal, state, and local governments, it is necessary to ensure that each government has the tools to fulfill its responsibilities. The ability to raise revenues via taxes will be considered first.

Experts have advised that certain types of taxes are most appropriate for central governments and others most appropriate for state and local governments. Taxes that are most appropriate for central governments are taxes on highly mobile factors, taxes used to redistribute income, taxes with unstable revenue patterns, and source-based taxes such as corporation income taxes. Taxes most appropriate for noncentral governments are taxes on immobile factors such as property, and residence-based taxes such as personal income and retail sales taxes.

TABLE 2. Percentage Reliance on Different Tax Sources by U.S. Federal, State, and Local Governments, 2015

Federal (%)State (%)Local (%)Total (%)
Individual Income80.017.52.5100
Corporation Income85.712.12.1100
Sales and Excise15.367.017.7100
Death and Gift79.719.60.7100

Source: Budget of the U.S. Government FY2017 and U.S. Census.

As Table 2 illustrates, the use of taxes in the U.S. system of fiscal federalism closely follows the tax assignment prescription of the experts.

One exception is that state governments collect a significant portion of corporate income tax revenues. This appears to violate the prescription against state and local government reliance on source-based taxes with unstable revenues. Another exception is that state governments raise about one-fifth of death and gift taxes, which violates the principle that state governments should not levy taxes on a mobile base.


One reason for federal grants to state and local governments (and state grants to local governments) is that revenues of the subcentral governments may not be sufficient to meet their expenditure responsibilities. In other words, the federal government may provide grants to state and local governments when their tax capacities are insufficient. Block grants that do not affect the relative prices of government services can be the appropriate type of grant to respond to this problem.

In some circumstances, matching grants might be the appropriate type of grant. Consider state environmental programs that have positive spillover effects on other states. Without a federal matching grant, no state would have an incentive to take these beneficial spillovers into account when setting expenditure levels. With a matching grant, the federal government could set an appropriate matching rate so that states freely choose the correct level of environmental spending. For example, if 25 percent of the additional benefits of environmental spending by one state spilled over to other states, the federal government could set the federal match of the environmental grant at 25 percent.

Table 3 shows how federal grants to state and local governments have changed from 1960 to 2015. Whether measured as a percentage of total federal outlays, total state and local expenditures, or the national economy (GDP), federal grants to state and local governments grew from 1960 to 1980. The 1980’s saw a decline in federal aid to state and local governments as a result of the Reagan administration’s policies intended to shrink the role of the federal government and increase the role of states. In the 1990’s, largely because of the growth of the Medicaid program, an open-ended matching grant, federal grants to state and local governments began to grow again. From 2010 to 2015 federal grants to state and local governments fell in importance.

TABLE 3. Trends in Federal Grants to State and Local Governments Federal Grants as a Percentage of:

Total Federal OutlaysState and Local ExpendituresGross Domestic Product (GDP)

Source: Budgets of the U.S. Government, FY2017 and FY2018.

The composition of federal aid to state and local governments has also changed in important ways. The proportion of grants to places, such as grants for capital investment, has shrunk, and the proportion of grants to individuals has increased markedly. The most important grant to individuals is Medicaid, which has become the single largest federal grant to state and local governments.


The federal government affects state and local governments in many other ways. First, indirect forms of federal aid to state and local governments will be discussed.

The federal government provides indirect aid to state and local governments through two provisions of the federal tax code. Individuals can deduct individual income, sales, real estate, and personal property taxes if they itemize deductions on their federal income tax returns. Tax deductibility is considered a “tax expenditure” because it represents a departure from the standard tax base, and without this allowed deduction the existing federal tax code would raise more revenue. This provision of the federal tax code may make it easier for state and local governments to raise taxes and increase spending.

TABLE 4. Cost of Major Forms of Aid to State and Local Governments, 2016

Type of AidDollars (Billions) % of Total
Tax Deductibility$90.712%
Exclusion of Interest on Debt$38.65%

Source: Department of the Treasury 2016 and Budget of the U.S. Government FY 2018.

A second form of indirect federal aid to state and local governments is the exemption from federal taxation of interest on state and local debt, which allows state and local governments to issue debt at lower interest rates than they would otherwise be able to.

Table 4 compares the cost of federal grants-in-aid to these two indirect forms of aid. Although federal grants to state and local governments account for over four-fifths of the total cost of federal aid to state and local governments, the cost to the federal government of indirect aid through the tax code is also significant.

The passage of the Tax Cuts and Jobs Act in December 2017, the first major overhaul of the federal tax code since 1986, is likely to significantly reduce the benefits of federal deductibility of state and local taxes and may also have a major impact on the municipal bond market and thus on the exclusion of interest on debt.

The federal government affects state and local governments in four other important ways. State personal and corporate income taxes are often linked to their federal counterparts. For example, some states that impose personal income taxes link their taxes to federal adjusted gross income (AGI). When the federal government changes provisions of the federal tax code that impact the value of AGI, this impacts state tax revenues unless states take explicit action to “decouple” from federal tax policy changes. Increases in federal AGI, as with the passage of the Tax Cuts and Jobs Act, will tend to increase state income tax revenues; decreases in federal AGI will tend to decrease state income tax revenues.

The federal government also imposes costs on state and local governments through regulatory requirements called mandates. One example is a direct federal order to implement a particular federal standard, such as the requirement that all public transportation systems be fully accessible to handicapped individuals. Problems with measuring the financial burden of federal mandates are considerable. The federal government also affects state and local governments through the Constitution, court interpretations of the Constitution, and federal law (other than mandates). These can all be considered “rules of the game.” For example, federal law relating to sales taxation makes it difficult for states to collect sales taxes from consumers making purchases via the Internet.

A final means by which the federal government affects state and local governments is through its management of fiscal and monetary policy. During periods of economic growth, state and local tax revenues tend to rise; during recessions, state and local government expenditure responsibilities tend to increase while revenues fall, straining state and local budgets.

SEE ALSO: Block GrantsDecentralizationEconomic DevelopmentEducationExternalities/SpilloversHealth Care PolicyLocal GovernmentMedicaidReagan, RonaldUnfunded MandatesWelfare Policy