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Intergovernmental Transfers to Local Governments

David E. Wildasin

May 2010, English

One often-anticipated solution for closing municipal fiscal gaps is to increase federal and state government transfers to cities. In this paper author, David E. Wildasin, examines this possibility. Under U.S. fiscal federalism, higher-level governments have no obligation to provide financial assistance to local governments in times of fiscal distress. The only exception is the federal emergency relief funds sent to state and local government to deal with natural or economic disasters. The reason behind the lack of obligation to provide financial assistance is that central support could pose a risk to the fiscal stability of both the donor governments and the recipients. The key concerns are moral hazard and softening of local budget constraints.

An examination of data from 1997 to 2005 reveals no evidence of significant increases in federal or state intergovernmental transfers to localities during recessions that lasted for six months or longer. State government transfers stayed at 35 percent of total local general revenue during this period, and cities and counties received about half of all state aid to local governments. Although direct transfers from the federal government have not been a significant source of local public funds, the federal government plays an important role in establishing tax exemptions that reduce borrowing costs for subnational governments. In addition, federal tax exemptions for state and local income and property taxes may boost housing and commodity consumption, thus increasing revenue from local sales, income, and property taxes. Federal aid through the Social Security, Medicaid, and food stamp and other welfare programs can also help to stabilize economically distressed areas.

Wildasin asserts that in the past adverse local fiscal conditions have not burdened the federal and state governments. He examines a panel data set of 1,000 municipalities over more than a quarter century and finds that city officials adjusted over time to long-term budget constraints, resolving their fiscal shortfalls by either increasing own-source revenues or decreasing spending. Although intergovernmental transfers did absorb some fiscal shocks, they played only a minor role in the adjustments.

This paper was presented at the Lincoln Institute’s Land Policy Conference of 2009 and is Chapter 3 of the book Municipal Revenues and Land Policies.