The American System of Fiscal Federalism
The American System of Fiscal Federalism
National revenue collection may not have been an explicit part of Henry Clay’s plan, but it arguably constitutes his greatest success.
The “American System” that gives its name to this essay series is perhaps most directly associated with mercantilism, industrial policy, and federal investments in infrastructure. An element that is not typically emphasized is the shift its proponents supported toward increased revenue collection at the national level. But that push is perhaps the most enduring and most successful element of this policy agenda, whether we consider federal revenue as a share of total output (GDP) or in comparison with state revenues.
The story of how the federal government came to collect so much money each year is well-trodden ground. Federal revenue amounted to between 1 percent and 3 percent of GDP between 1820 and the Civil War (setting aside concerns that measuring GDP in the antebellum period borders on the impossible). Revenues during this period derived almost exclusively from customs duties and sales of federal lands. Wartime expenditures during the Civil War, however, exceeded what revenue could be collected through import tariffs. This triggered the introduction of additional taxes—mostly excise taxes and what we would now call corporate income taxation—that accounted for over half of federal revenue by the turn of the twentieth century. By that time, revenue as a share of GDP had returned to the low, pre-Civil War levels. It was the introduction of the income tax during the Progressive Era, the two World Wars, and the introduction of payroll taxes for financing Social Security and Medicare that gave rise to the current revenue raising apparatus, which brings around 17 percent of GDP into the federal coffers each year.
How the relative spending and revenue-collecting roles of federal and state governments have evolved since the days of Alexander Hamilton and Henry Clay is less well known. America’s system of fiscal federalism reached its current form only gradually, through a process of trial and error, and remains a work in progress. The division of tasks across levels of government has by no means been clear or constant. The local, state, and federal governments have not simply grown at steady rates from a baseline established by the federal government’s assumption of state debts following the Revolutionary War. In fact, even after the Revolutionary Era, the federal government’s military and financial capabilities remained limited, and various states had to take on significant amounts of debt to fund their own defense during the War of 1812. The federal government only reimbursed the states for these loans after the war.
With those wartime debts settled, the states were left with practically no debt. They barely collected taxes either, and largely financed their spending with revenue from investments—especially in banks—and land sales. Perhaps inspired by this convenient state of affairs, the states became enamored of all sorts of debt-financed “internal improvements,” like banks, canals, and railroads. Other factors played a role too. The Jacksonian push to reduce federal activity and to weaken the Second Bank of the United States created more scope for state-led development efforts, particularly in a context of rapid population growth in the Midwest. As a result, annual borrowing by the states grew by a factor of ten between 1820 and the late 1830s.
That is when the chickens came home to roost. The Panic of 1837 and the depression that followed made capital dry up and rendered many state-owned enterprises worthless. Over the next few years, Arkansas, Illinois, Indiana, Louisiana, Maryland, Michigan, Mississippi, Pennsylvania, and the territory of Florida all defaulted on their debt, while a number of other states barely avoided that fate. A movement for federal debt assumption arose but was defeated, and the states went through a sometimes lengthy process of debt repudiation and restructuring.
Frustration with this fiscal mismanagement led to an institutional innovation that remains of central importance to the American system of fiscal federalism. Before 1840, not a single state had adopted constitutional restrictions on deficits and debts. By 1855, nineteen states had done so. Currently, every state but Vermont faces a constitutional or statutory balanced-budget requirement.
This has important implications for the relationship between the states and the federal government. A balanced-budget requirement forces states to reduce spending when a recession hits and tax revenue goes down. This kind of pro-cyclical fiscal policy is typically seen as counterproductive, as it reduces outlays just when spending needs are the greatest and aggregate demand is falling short. To make up for this, the federal government has taken on the primary role in macroeconomic stabilization. It now typically runs large deficits and provides significant funding to state governments during recessions.
In response to the COVID-19 pandemic and the associated economic crisis, for example, the federal government sent some $900 billion in additional grants to state and local governments, much of it general funding not earmarked for any particular functions. This is now widely seen as having been excessive, and particularly problematic given the inflationary environment in which we now find ourselves. Frustratingly, federal support was perceived to be too meager after the global financial crisis. To avoid the risks of both excess and insufficient funding, a better approach would rely on automatic revenue stabilization. In previous writings, we have laid out a number of ways to accomplish this. Perhaps our preferred option would be for the federal government to offer “revenue insurance” to the states. Under such a scheme the states would pay premiums during boom times and receive payments in line with the shock to tax bases in downtimes. Such an approach would combine the lessons of the 1830s and 1840s with those of the past two decades. During downturns, it would enable the states to avoid disruption in delivering on the important responsibilities they bear.
But business cycle management is only one part of the story here. The scale and scope of federal and state public sectors have undergone dramatic changes since the era of railroad construction. Many of these changes are reflected in the evolution of intergovernmental spending, which refers generally to grants from the federal government to state and local governments. These grants reflect the ability of the federal government to collect large amounts of revenue without having to worry, as states must, about the pressures of tax competition. As President James Madison put it in 1815: “Whilst the States individually, with a laudable enterprise and emulation, avail themselves of their local advantages by new roads, by navigable canals, and by improving the streams susceptible of navigation, the General Government is the more urged to similar undertakings, requiring…national means.”
As late as 1959, this vision of the federal government providing the means for important infrastructure projects did in fact dominate its payments to state and local governments. In that year, transportation grants, mostly from the highway trust fund, constituted over 40 percent of total grants to state and local governments. But today the corresponding number is just below 10 percent.
This shift reflects a key development over the past seventy years: the increase in the role of state governments in administering and financing redistribution. This has occurred largely through two mechanisms, the second of which illustrates the importance of “national means” in dealing with what Henry Clay would surely have seen as a more localized responsibility.
On the revenue-raising side of the ledger, there has been a substantial increase in the reliance of state governments on income taxation, which tends to take a more progressive structure than alternatives including property and sales taxes. From the middle of the twentieth century through the beginning of the twenty-first century, state governments’ income tax revenues rose from an amount equivalent to just 0.3 percent of GDP to an amount equivalent to 1.9 percent of GDP. As a share of states’ revenues, this involved a roughly three-fold increase from 6.4 to 18.2 percent of states’ own-source general revenues. By 2019, according to a Census Bureau summary, state governments’ income tax collections had reached $412 billion, which amounts to over one-quarter of states’ own-source general revenues.
With respect to spending, the role of state governments in financing and administering the safety net has occurred largely through the growth of the Medicaid program. This growth, in turn, reflects the general rise in health expenditures as well as the gradual increases in the populations eligible for Medicaid’s free public health insurance. Created through the Social Security Amendments of 1965, enrollment in the Medicaid program plateaued at roughly 20 million Americans through most of the 1970s and 1980s. In 1989, it covered a mere 8 percent of the U.S. population.
Since then, Medicaid has experienced steady and substantial enrollment increases, fueled by federal reforms that enable states to obtain federal funding for their coverage of additional populations, with the 2010 Patient Protection and Affordable Care Act being the most prominent among them. If one includes enrollment through the complementary Children’s Health Insurance Program (CHIP), combined Medicaid and CHIP enrollment had reached 71 million, or 21.6 percent of the U.S. population, by the end of 2019. During the Covid-19 pandemic, a linking of federal aid to a state commitment not to disenroll beneficiaries during the public health emergency has contributed to a substantial additional rise, such that Medicaid and CHIP combined to cover roughly 92 million individuals as of late 2022.
A large share of all this Medicaid spending is funded by the federal government. Even during the pre-pandemic years, grants to states for Medicaid amounted to almost $400 billion annually. Through a formula that is more generous to low- than to high-income states, the federal government typically picked up the tab for between 50 and 83 percent of all state Medicaid spending. Like many of today’s federal payments to state and local governments, these payments are perhaps most easily rationalized as an effort to keep the states from engaging in a race to the bottom when it comes to anti-poverty efforts.
National revenue collection may not have been an explicit part of Henry Clay’s plan, but it arguably constitutes his greatest success. That said, it is hard to argue that the way we got here was through the careful implementation of a plan. Instead, a process of trial and error, dominated by state-level instability and the demands of war, led to the development of the current American system of fiscal federalism. It has become a system with a federal government that raises immense amounts of revenue and that both directs and subsidizes the state governments as they, too, operate with more resources than ever before.
This article is part of the American System series edited by David A. Cowan and supported by the Common Good Economics Grant Program. The contents of this publication are solely the responsibility of the authors.
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