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New study concludes: There are few things as expensive as free federal money

Please download and read the new study: Impact of Federal Transfers on State and Local Own Source Spending.

“Free is a very good price” announced the 1980s pitchman for a local appliance store known for it’s buy-one-get-one offers. But, like most things in life, the BOGO offers had some hitches (Like you had to spend $399[!] on a 19-inch color TV in order to get a 12-inch black-and-white TV for “free”).

Regardless, almost 35 years later, “free is a very good price” is part of the Portland lexicon. But, Portland’s not alone. Throughout the U.S., state and local officials pick up the bullhorn and shout “free is a very good price” when the federal government dangles dollars in front of their faces.

We see this play out across the U.S. States that cannot afford their existing Medicaid programs have expanded coverage under the Affordable Care Act, thanks to the promise that federal funds will pay for a huge portion of the additional costs of coverage. Cities are building slow moving streetcar systems because federal dollars will cover half of the construction costs.

What’s often missed is a simple fact: Federal money isn’t free.

Money “from the feds” is money from those who pay taxes to the feds. Those people and businesses are in every state. If the feds didn’t take those tax dollars, you’d have those dollars in your pocket or your bank account. Sending the dollars to Washington, D.C. only to have D.C. send back a fraction of those dollars doesn’t make you richer, it most likely makes you poorer.

There’s another way in which federal money isn’t free. Nearly every single dollar sent to state and local governments comes with strings attached.

Research I just completed finds that each additional dollar of federal money sent to the states is associated with an average increase of 82 cents in new state and local taxes. Across all states, a hypothetical 10 percent increase in federal grants state and local governments would be associated with with approximately $50 billion in additional increased state and local taxes, charges, or other revenue sources, amounting to an additional government burden of $158 per person.

How does federal funding increase the state and local tax burden? The U.S. Government Accountability Office identifies two ways that strings attached to federal grants can increase state spending: (1) matching fund requirements, and (2) maintenance of effort requirements.

Many federal grants require state and local governments to match federal funding with their own spending in order to receive the federal dollars. This allows bad public policy to masquerade as good policy, simply because it appears to be cheaper than superior alternatives. Much like coupons try to entice consumers to buy something they don’t need, federal matching funds entice state and local governments to pursue projects that they don’t need or can’t afford. By drawing limited state tax dollars toward the priorities of D.C., these matching requirements put pressure on state and local policymakers to raise taxes and fees in order to fund existing priorities.

Of course, these federally-funded policies often fail to deliver on their promises, but that isn’t something D.C. tends to concern itself with. For example, the Feds will supply matching funds to build a project, but often leave the costs of operating the project to the state and local governments. For example, federal funds help build the Portland, Oregon streetcar, but nothing to operate it. Today, Portland’s streetcar operations run at a deficit of $4.5 million a year—and growing. That deficit is filled by diverting the city’s money from much needed road repairs and maintenance. To fill that hole, Portland is proposing a citywide 4-cents-a-gallon gas tax. Without the federal funds, Portland wouldn’t have a streetcar, which means it would have millions more dollars for road repairs and maintenance, which means it wouldn’t need millions in new taxes to fund road repairs and maintenance. Who would have thought that free federal money could be so expensive?

The GAO also points out that, in addition to matching funds, state and local governments are sometimes required to maintain spending in the future as a condition of receiving federal grants. For example, the federal stimulus package passed in the wake of the Great Recession required states to provide a minimum state appropriation to higher education. States failing to maintain higher education spending at pre-recession levels would jeopardize a large chunk of their earmarked stimulus money.

For example, a publication from the American Association of University Professors looked at state higher education spending data and found that the threatened loss of federal funds was a key driver of the higher education budget for many states. Spurred on by the pressure of federal money, states spent more on higher education than they otherwise would have in the face of a recession and shrinking state budgets. Some were forced to increase taxes. AAUP notes that it is no coincidence that Oregon set its higher education funding at almost precisely the cutoff amount necessary to avoid the threatened cuts. It is also no coincidence that the state passed the largest income tax increase in Oregon history during the time the federal stimulus program was in action.

Milton Friedman once said “Nothing is so permanent as a temporary government program.” The first annual cash grant to states was made under the Hatch Act of 1887. More than 125 years later, the Hatch Act is still in effect—distributing tens of millions of dollars to states every year (and requiring a dollar-for-dollar match from states receiving federal money).

Perhaps knowing that federal funding translates into pressure to raise state and local taxes, those in elected office will take the long view and reject the empty promises of “free” federal dollars. One can only hope for such leadership and vision from our elected officials.

Next time your local politician/policy wonk/whatever dangles federal dollars in front of you and says “free is a very good price.” Remind him or her of some other wisdom from the ages:

  • “If it sounds too good to be true, it probably is,” or
  • “There’s no such thing as a free lunch,” or
  • “You can’t get something for nothing.”

Or how about a new phrase: “There are few things as expensive as free federal money.”

For more information, please download and read the new study: Impact of Federal Transfers on State and Local Own Source Spending.