Beyond the financial crisis: the future of fiscal federalism in the United States

The Great Recession brought significant fiscal consequences for all levels of government in the United States. The federal deficit grew to record proportions as a share of gross domestic product (GDP) during peacetime, while states and localities experienced the deepest fiscal crises in the post-war era. State and local fiscal responses were predictably pro-cyclical, exacerbating subnational economic downturns through budget cuts and tax increases. The national government, on the other hand, responded by undertaking an economic stimulus program of over 5 percent of GDP, much of which was delivered through the state and local sector, which helped mitigate the worst effects of the downturn for several years. However, after several years of stimulus, the federal fiscal pump was reversed, as polarized conservative leaders captured the agenda by forcing the Obama Administration to cut the deficit through a ten-year spending reduction plan. The cyclical fiscal effects of the financial crisis were more than just temporary in nature, as they interacted with underlying structural fiscal deficits and longer-term pressures in many states and local governments. Large cities and counties, such as Detroit and San Bernadino, slipped into bankruptcy, as the recession proved to be the last act in a decades-long erosion of fiscal capacity and economic wealth. States were forced to be bankers of last resort, saddled with tackling their own fiscal imbalances as well as stepping in to rescue cities that went over the fiscal cliff. Notwithstanding significant improvements in the national economy and reductions in the deficit from 10 to 3 percent of GDP, the federal government was missing in action, hamstrung by gridlock and gripped by record polarization between the two parties. The shifting and volatile fiscal fortunes of the US intergovernmental system reflects the weak institutionalization of intergovernmental fiscal collaboration at the national level. A near-record federal stimulus that modeled the best thinking in public finance was quickly followed by federal indifference and passivity in the face of major fiscal pressures experienced by many subnational governments. The institutions of fiscal collaboration that had emerged during the era of cooperative federalism in the 1960s had largely disappeared by the 1990s. Fundamental political incentives that formerly provided incentives for bargaining and collaboration across levels of government collapsed in the wake of the nationalization and centralization of political parties and the centralization of media and interest groups. In its wake, federal intergovernmental policy-making became less systematic and more opportunistic – collaborative when, and only when, national officials perceived it to be in their interest to engage state and local capabilities. Going forward, all levels of government will be struggling with the fiscal implications of an ageing society and rising health-care costs. Whether it be rising Medicare costs at the federal level or employee pensions in state and local governments, all levels of government will be faced with paying for the elderly and their doctors from a slower growing economy featuring fewer workers. In the past several years alone, pension and health entitlements and revenue slippage are crowding out other priorities, such as education and infrastructure, at all levels of government. With common fiscal challenges, intergovernmental fiscal challenges are optimally addressed through fiscal collaboration. While some vertical fiscal equity is achieved through federal grants to states for health care, the United States has little tax sharing or fiscal equalization commonly found in other federal systems. The question facing the United States is whether and how it will step up to fashion truly intergovernmental fiscal solutions to long-term fiscal challenges that pervade public finances at all levels of government.