The coronavirus crisis has become a crisis of federalism, as states face plummeting revenues and soaring entitlement obligations. Despite $340 billion in emergency funding through the CARES Act and a $50 billion hike in federal assistance for Medicaid, states remain deep in the red. The National Governors Association has called for an additional $500 billion in “unrestricted fiscal support” to help meet budgetary shortfalls, and House Democrats have made further assistance for states a centerpiece of their proposed $3 trillion HEROES Act.

The state fiscal crisis is so acute because it exposes structural flaws in federalism’s current model, whereby the federal government provides partial funding for states to manage entitlements such as Medicaid and unemployment insurance. This arrangement has led to program funds being inequitably distributed, inadequately focused on those who most need assistance, and destined to fall short in recessions, when they are most needed. The prospect of generous federal matching funds for certain entitlements has led states to prioritize them at the expense of responsibilities for which they bear the full cost—putting at risk their ability to finance education, infrastructure, and police.

Instead of propping up these dysfunctional arrangements with ad hoc bailouts, Congress should take the opportunity to place American federalism on a sounder foundation by making the federal government fully responsible for mandatory entitlement programs, letting states focus on activities that they can sustainably finance by themselves.

The increased fiscal vulnerability of states owes much to the rise of joint state-federal entitlements. As a consequence, from 1949 to 2019 the growth of spending by state and local authorities (from 7 percent to 14 percent of GDP) has outpaced the growth of spending (from 13 percent to 18 percent of GDP) by the federal government. By providing more than half of funding for state health and public-assistance programs, the federal government encourages states to expand benefits and enlarge eligibility during economic expansions, leaving them financially exposed and needing bailouts during downturns.

State management of federally funded entitlements is a vestige of the New Deal coalition that established the American welfare state, when congressionally pivotal southern Democrats sought guarantees that newly created programs would not undermine Jim Crow. Joint state-federal programs have continued to proliferate, fueled by pork-barrel politics. In 2018, state and local government entities were eligible to apply for 1,274 federal grant programs—up from 664 in 1998.

In normal times, a combination of state and federal payroll taxes is deposited in an Unemployment Trust Fund to pay unemployment insurance. States administer the program and set eligibility and benefit levels. The Department of Labor had estimated that $27 billion was to be spent on unemployment benefits in 2020, with state unemployment taxes providing 84 percent of the associated $46 billion in expected revenues. But with the number of Americans claiming unemployment assistance soaring from 1.7 million in early March to 24.9 million in mid-May, it became clear that the federal government had to put in extra money.

State administration of the $268 billion expansion of unemployment insurance established by the CARES Act has been a fiasco. Some states have been unable to process claims due to 40-year-old computer systems, while others were not able to handle applications fully until May. Two months after the CARES Act, a third of unemployment benefits had still not been paid.

States similarly manage the Medicaid program, which provided health-care coverage to 70 million low-income Americans in 2018. For every dollar they spend on medical services for those eligible, states can claim between one and nine dollars from the federal government. In 2018, Medicaid cost $588 billion, with state funds accounting for $230 billion—but those numbers are also expected to soar as the number of Americans that fall under the program’s income-eligibility threshold increases.

The combination of federal funding with state management is touted as marrying the power of the national treasury with the flexibility of the states, but in practice it serves to divorce the structure of the welfare state from priorities of need and fiscal responsibility. Whereas national entitlement programs are designed to focus assistance on individuals with the greatest need, federal matching funds allocate resources according to the ability of states to put up money of their own.

In 2017, Louisiana collected a higher share of personal income in state taxes (9.9 percent) than Massachusetts (9.7 percent), but its smaller tax base leaves it less able to claim federal matching funds. Whereas Massachusetts received $15,482 in federal Medicaid funds per resident under the federal poverty level in 2018, Louisiana received only $9,474—though both are “expansion” states. Whereas unemployment benefits in 2019 went up to $795 per week in Massachusetts, residents of Louisiana were entitled to no more than $247.

The mix of state management and federal funding invites states to manipulate and inflate costs. Under Medicaid, 49 states tax medical providers for the purpose of increasing the amounts for which they can claim reimbursement from the federal government, subsequently compensating hospitals for participating in the scam. The federal government pays 100 percent of food stamp costs, but the states are responsible for assessing eligibility. They have often failed to enforce asset tests, and program funds have not flowed to those in greatest need.

States have traditionally imposed balanced-budget requirements on themselves in order to convince bond markets to lend to them at good rates. Doing so means, however, that in recessions, Medicaid and Unemployment Insurance caseloads soar at precisely the moment when revenues plummet and states are least capable of paying for the entitlements. Federal assistance structured as matching funds does not expand unless states can find more of their own money to put up. Block grants don’t expand at all, while ad hoc allocations for states to deal with the coronavirus have been governed more by the logic of pork-barrel politics than the distribution of need.

Though states have recently sought to protect themselves from the business cycle by accumulating savings during economic expansions, the median state has less than 8 percent of annual spending in its rainy day fund. Some states have worked harder than others to save for a downturn. As Joshua Rauh of Stanford University notes, “taxpayers in states such as Wyoming, which had over a year’s worth of expenditures in their rainy day fund, or Texas with 19 percent of a year of expenditures, might ask why they should bail out states such as Illinois, which has zero.” States similarly vary in the extent to which they have adequately funded unemployment-insurance trust funds—with 31 states setting aside the full amount recommended for a downturn, while New York has vested only 36 percent and California 21 percent of the funds recommended.

Even if bailouts patch up state finances for a while, federalism’s fiscal structure can no longer hold its own weight; thorough reform is needed to avoid these problems worsening in the future. This will require a clearer division of state and federal roles, as Paul Peterson of Harvard University argues in his book The Price of Federalism.

To align policy responsibilities with the capacity to pay for them, Washington should assume responsibility for entitlements where it currently imposes a mix of funding and obligations between itself and the states. For example, mandatory Medicaid spending should become entirely federally funded and folded into the Medicare program. States would retain the ability to offer additional health-care benefits if they can sustainably pay for them with their own funds. Similarly, the federal government should assume direct responsibility for unemployment insurance, which would strengthen the safety net across the country, making it easier for people to relocate in search of work and allow benefits to be dispatched directly through the Social Security system.

The federal government is well-suited to operate entitlements, which automatically expand and contract to counteract the effects of the business cycle, as it can run substantial budget deficits. From 2007 to 2010, the American economy benefitted from a highly expansionary fiscal policy at the national level, relative to other countries. But this was largely offset by tax increases and spending cuts at state and local levels of government, which were needed because of balanced-budget requirements. Whereas federal revenues fell by 13 percent during the subprime recession from 2006 to 2009, state and local own-source revenues increased by 9 percent.

Relieved of the responsibility for entitlements, state and local government expenditures (two thirds of which go to education, police, fire services, prisons, parks, and transport), would become more stable over the business cycle. With a reduced need for income and sales taxes, states could also rely more on property-tax revenues, which are less exposed to macroeconomic risks.

Federal matching finance for entitlements is a relic of the past that has encumbered lower levels of government with responsibilities for which they are poorly suited. Rather than providing bailouts to sustain this perilous and inequitable arrangement, Congress should take full financial and administrative responsibility for entitlements that it wishes to fund—and let states focus on programs that they’re capable of financing by themselves.

Photo: ngus-Kruklitis/iStock


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