Getting America out of Debt

Why Federalism Fails, and Four Ways to Fix It

Federalism is a great idea. Too bad it doesn’t work. These are hard words for conservatives and constitutionalists. ‘Tis far easier to blame socialists from Europe, home grown elitists, power hungry bureaucrats, or even a sinister secret conspiracy involving robber barons and Jewish international bankers for centralizing government over the past century. Some of these players did indeed contribute to government growth at the federal level, but they were not the root cause. We started centralizing our government during the Progressive Era because federalism wasn’t working well enough. Government trends to the national level to this day, under both Democratic and Republican administrations (remember No Child Left Behind?).

But federalism is a good idea. It can make government more scientific, more efficient, and more accountable to the people. Federalism has much to offer conservatives and liberals alike – if only it worked.

And it can be made to work. We just have to recognize the failure modes and devise some decent workarounds.

Feedback and the Failure Modes of Federalism

Federalism fails because of feedback, both negative and positive. First the negative feedback:

Picture two imaginary American cities: East Fremont and West Fremont. The city council of East Fremont decides to end their homeless problem. They allocate money to build the finest homeless shelters in the state and pass an ordinance requiring the city to expand the shelters as needed. The problem is solved! for a short while. Then the homeless in West Fremont hear about the wonderful treatment the homeless are receiving in East Fremont and migrate eastward. The shelters overflow. Costs rise. Beggars pester pedestrians in downtown East Fremont. Business declines and tax receipts follow. Hearts harden and the council closes the shelters. Homeless advocates give up lobbying local governments. They travel to the state capital and a new State Bureau of Homeless Shelters is born. Thus government moves from local to central.

Libertarians and small government conservatives take note: similar dynamics apply to local charities as well. A generous community attracts the needy, which thus punishes their generosity. Pressure arises to centralize charity as well, with some of the same problems of accountability. But not all: unlike central government, it is possible to have multiple charities operating at the same level. Donors can vote with their dollars. Since a private charity is not constrained to uphold equality under the law, even a monopolistic centralized charity can perform experiments more readily than a central government. And centralized charities can specialize. We have but one federal government. While we can expand departments and bureaus indefinitely, we have but one federal legislature and chief executive. Whether these advantages outweigh the fundraising difficulties of private charity vs. government I leave as an exercise for the reader.

This particular failure mode is unpleasant for liberals, but it is not a catastrophic failure for government in general. Government still functions. Local and state governments can still innovate and push forward with generosity as long as the additional attraction to the needy is offset by the cost of moving. (Behold how government centralized as transportation technology improved.)

Negative feedback constrains the benefits of experimental government. A local or state government which is too successful with its innovation can end up shouldering the load of its neighbors.

Positive feedback magnifies the downsides of experiments gone bad.

Consider now “essential” government services, services such as police protection, streets, water, sanitation, schools, parks, etc. (I put the word “essential” in quotes because every one of these services has been successfully been privatized as some place and time. Once again, I leave it to the reader to decide which of these services is “essential” for government to provide.) For the purposes of this feedback loop, an “essential” service is one which serves the taxpayers. A local government which performs these services well attracts businesses and net taxpaying residents.

Back to our two imaginary cities: this time the widget factory in West Fremont closes down. Business tax receipts decline. Unemployed widget workers fail to make mortgage payments. Foreclosures rise; property values decline, with property tax receipts following. The city council cancels the annual Cheese Festival. The police department closes down its vice unit and undercover operation and focuses its efforts on property crimes and violence, leaving the dopers and prostitutes alone as long as they are discreet. Libertarians rejoice. Down with Big Government!

But suppose those cuts are not enough? If the city scrimps too much on school funding, parents who can afford it will move out to the suburbs, driving property values down further. If the city cuts the police force too much, theft and vandalism will rise, driving out taxpayers and businesses. If the city cuts back too far on street and sidewalk maintenance, businesses will move out of downtown, driving property values down. If the city raises tax rates to make up for lower property values, then property values will decline further, and more businesses will leave. The city is caught in a death spiral. Bad times beget worse times. Positive feedback ain’t so positive.

This is no mere theory. Behold the Lost City of Detroit. Such catastrophic local failures cause even staunch conservatives to back away from on their ideals of traditional federalism, and pushing government down to the local level.

Negative Feedback from the Market

Not all is lost. The free market is a great leveler, geographically. A city or state in decline is a reservoir of cheaper labor, and greater tolerance of the dirt and ugliness that industry generates. Note the spectacular economic growth of China, today. And decades ago we had the rise of Japan and the American South at the expense of the American Rust Belt, for similar reasons.

Many of the cities and states of the Rust Belt are trapped in a death spiral in part because they cling to legislation and privileges affordable during the postwar boom times. To attract fresh business, these jurisdictions need to create a more business friendly climate: laxer regulations on labor, location, pollution, etc. Indiana has just made a major move in this direction by becoming a right to work state. Liberals are unhappy.

But even most Republicans would be unhappy with Chinese levels of labor and pollution deregulation. We are still a rich country overall and are loath to have Third World enclaves within our borders. And so Republicans have joined in compromising federalism to maintain minimum standards.

The current measures, however, have not sufficed. Detroit declined despite a wealth of federal transfer payments to states, cities and individuals. Let’s look at several solutions – some good, some bad — other than moving yet more government to the state or even federal level.

Federal Tax Deductions for State and Local Taxes

Currently, you can deduct many of your state and local taxes from your taxable income for federal income tax purposes. This is an indirect means by which the federal government directs some of its tax collecting might down to the state and local level. The beauty of this system is that it ties no strings to the states and localities as to how they spend the extra money they can raise because of this deduction. A downside is that this approach is poorly targeted.

These tax deductions may dampen the positive feedback loop which drives net taxpayers out of poor jurisdictions which must impose higher rates to provide basic services, but they do so less than one might expect. A taxpayer in a 28% federal tax bracket still feels 72% of the sting of state and local taxes. This does make the tax rate of a locality a bit less of an issue for a high income taxpayer than if the taxpayer felt 100% of the sting. However, this deduction also applies to wealthy taxpayers living in prosperous jurisdictions, which makes it very untargeted.

But it gets worse. The tax deduction has no impact on low and middle income taxpayers whose total deductions fall below the standard deduction. These tax deductions provide extremely little help for localities from which the well-off have already moved out and massive unneeded help to wealthy enclaves. This is not a liberal tax deduction.

It is not a libertarian or small-government conservative tax deduction either. The deductibility of state and local taxes from federal taxable income encourages the well off to incorporate wealthy enclaves and to buy luxury services through the local government instead of on the private market: golf courses, tennis courts, plush parks, posh schools, etc. bought through the local government merit a subsidy from Uncle Sam. Wealthy states become big government “blue” states in order to dodge federal taxes.

I thus oppose this solution on liberal, conservative and libertarian grounds. This is one of the first tax deductions I would remove in order to balance the federal budget.

Tax Free Municipal Bonds

Tax free municipal bonds share all the benefits and downsides of the deductions for state and local taxes. But tax free municipal bonds share some extra downsides:

They encourage localities to go into debt. This introduces yet another feedback loop: the locality which gets overly ambitious during good times has higher fixed costs during bad times. Debt also reduces democratic accountability. Today’s city council can vote for goodies that a future city council must pay for.

Tax free municipal bonds also encourage eminent domain abuse. Finance a development using municipal bonds and you get a lower interest rate because they are tax free. When the municipality is involved in the development, the local government is tempted to use eminent domain.

Tax free municipal bonds soak up potential angel capital. Risky new ventures need capital from investors who can take risks. This rules out banks. And our highly regulated financial system rules out floating shares to the public in the early stages. Angel investing is the job for the rich. Let grandma hold municipal bonds as part of her retirement portfolio.

I thus oppose this solution as well. I would make municipal bond interest taxable as one of my recommended tax increases to balance the federal budget. (This would apply to new bonds. Already floated bonds should be grandfathered. Ex post facto law is a bad idea.)

Block Grants

Block grants to the states were a favorite Republican idea during the Reagan years, and for good reason: if done with discipline, they would work.

Block grants would be progressive, more progressive than the aforementioned tax loopholes. If the grants went to states purely by population, states with a poorer average population would be net recipients of block grant money. The same holds for state block grants to localities. A state which divvies up its sales tax revenues to localities by population transfers income from wealthy localities to poorer localities.

Block grants preserve local accountability as long as they are not overly large. High spending states (or localities) do not get more money from the central government because they spend more. With the tax deductions for state/local taxes, conversely, big spenders do get subsidized in proportion to their spending. Those of a libertarian bent should support block grants over tax loopholes. They only time block grants make state or local government bigger is if the block grants exceed that which is needed for frugal government. (And even there, a libertarian state could opt to give its residents a dividend from the excessive block grant.)

The main drawback to block grants is that central governments lack the discipline to give them. General block grants give way to targeted block grants (for Medicaid, education, etc). Once targeted, the central legislature needs to define what spending qualifies under each category. Lobbyists converge asking for more strings to attach. Block grants can quickly degenerate into conditional grants or backdoor centralization. “Unfunded mandates” proliferate.

Progressive Taxes at the Federal Level

Here is an approach to federalism that liberals might like: make the federal income tax more progressive. Do so not just by raising taxes on the rich, however. Cut them for the middle class and finance those cuts by cutting off federal aid to the states. Let the states fund themselves with flat/regressive taxes like sales taxes and lotteries. Let the federal government fund itself primarily by taxing the rich.

This proposal runs counter to today’s Republican talking points, but is how Republicans once governed. Look back to the Eisenhower years. Federal taxes were quite progressive, but the federal government focused on matters such as defense, and left more for the states to take care of on their own. With aid to the states reduced/eliminated, progressive federal taxes can lead to a fairly flat tax rate overall. States and localities have a harder time taxing the rich than the federal government, so state/local taxes tend to be flat to regressive.

This proposal has all the benefits of block grants with less temptation/opportunity for the federal government to add mandates on the states. Taxes at the state and local level are tied to services, bringing accountability. This proposal also has the benefit of being somewhat proven; it resembles government we once had.

But there are downsides. Progressive taxes can be complex. (And the high top rates of the 1950s were well above the Laffer Curve maximum, so much so that a Democrat, John F. Kennedy, called for lowering them.)

A Citizen Dividend

Progressive taxes can be complicated; unencumbered block grants are like dieting: good in theory but rarely practiced. We have yet another means to put a floor on unpleasant feedback, one which eliminates the federal welfare system, shrinks state welfare systems, and fights poverty: a citizen dividend, otherwise known as a basic income guarantee, or as I like to put it: free money from the government for all citizens. Take all federal aid to the states, all federal welfare, all federal entitlements, and the value of personal tax exemptions and the lower tax brackets. Divide the number by the total number of adult citizens and send it back to individuals on a monthly basis. We now have a safety trampoline instead of a safety spider web.

You want to live like a hardcore eco hippie? You might get by without working. Or you might go out and pick tomatoes or something when the inspiration hits. For those who want to join the consumer society: get a job. Minimum wage plus dividend = living wage. No able bodied person needs to be poor unless they choose to be. Farmers could find seasonal labor locally. Rich Republicans could easily hire someone to mow the grass. Libertarians get a massive reduction in the number of meddlesome bureaucrats. Laborers have a fallback position so they don’t have to submit themselves to one of the nightmare jobs featured in Mother Jones magazine. It’s a win-win-win-win situation. It’s a big enough idea that I devoted an entire web site to the proposition.

States and even the poorest localities will have a tax base to work with. There will be some who need more welfare than the citizen’s dividend: orphans, the desperately ill, the mentally ill, etc. But with a citizen’s dividend from the federal government, the numbers would be manageable at the state and local level, or even by private charities. I leave it to the reader to decide which of these are optimal.

Libertarian purists would object to the idea, as it still requires taxes. In the spirit of fairness I’ll wind up with some solutions from the radical libertarian playbook.

And Finally, Some Solutions from the Radical Libertarians

Many essential services could be privatized. Not long ago I lived on a private street, drank water from a private water company, flushed it down a private sewer, and had my garbage picked up by a private waste company. But privatization of such services doesn’t fully answer the feedback problems described above. What happens to a neighborhood whose residents don’t pay their utility bills? What happens to the price of garbage pickup when half the people in the neighborhood save money by taking their garbage to the dump, thereby  reducing economies of scale?

When I talk of radical libertarian solutions, I’m talking a bit more radical. For example, instead of having a police force adequate to arrive quickly, teach all law abiding citizens how to handle firearms. Encourage people to get to know their neighbors and watch out for strangers doing suspicious stuff. While this may sound scary, it is how we lived before telephones save perhaps in the densest urban areas.

Another possibility would be for a declining city with a high crime rate to allow wealthier neighborhoods to wall themselves off if they pay some extra property tax (to make up for the lost through streets). A somewhat ugly solution, but one with plenty of historical precedent.

Declining schools are notorious for triggering the flight of net taxpayers from a city. Replace urban public schools with vouchers and the dynamic reverses. Cities allow more school choice than suburban areas since you can have several schools within walking distance. (I’ll have more to say on this in the future.) Liberals may object that school privatization would result in resegregation. It might. But it would also bring better schools to the nation’s minorities.

Minorities would benefit especially from the final radical libertarian solution: allow jurisdictions in economic decline to legalize vices forbidden elsewhere. Reagan did it when he allowed Indian reservations to run casinos. We could do the same for marijuana, prostitution, and even the harder drugs if the central government would make allowances. Cities and/or neighborhoods which want to remain drug free could continue to do so. Today’s scary crime-ridden cities could become adult tourist areas for those who desire headier intoxicants than we allow in family-friendly cities. The drug dealing exists in such neighborhoods already. We are simply replacing potential jail time with taxes. Given how racial minorities are doing the most jail time under the current system, this is an extremely progressive proposal.

Four Viable Solutions to Make Federalism Work

Federalism can fail, but we can make it work. I have presented four different viable options: block grants, progressive federal taxes, a citizen dividend, or radical libertarianism at the local level.  Take your pick. If you find none of these acceptable, don’t come whining as yet more government functions move up to the federal (and eventually United Nations) level.

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