Rich States, Poor States: Assessing the Design and Effect of a U.S. Fiscal Equalization Regime

Abstract

Unlike most of the world’s federations – including Australia, Canada, Germany, India, South Africa and numerous others – the United States has no system of federal equalization grants in place to reduce fiscal disparities among its subnational governments. Only at the state level, through policies designed to mitigate property tax disparities among school districts, has equalization been tried in the United States. The federal government has never adopted, nor has it ever seriously considered, an equalization policy for the states. This article represents the first comprehensive scholarly treatment of a possible U.S. fiscal equalization regime. It reviews the most recent data relating to fiscal disparities among the U.S. states and reports the results of simulations showing the overall cost and distributive effects of adopting a Canadian-style equalization regime in the United States. Two alternative policies are examined, one based on the “representative tax system” methodology employed in Canada and a second, known as the “representative revenue system,” that employs a slightly broader measure of state fiscal capacity. Depending on the methodology employed, the cost of a U.S. equalization policy (based on 2005 data) would be in the range of $70-$110 billion per year, or roughly 1 to 1.5 times the annual cost of the current income tax deduction for state and local taxes. Under both methodologies, as well as alternative formulas adjusting for regional cost-of-living differences, the principal beneficiaries would be the so-called “red states” of the South. On a per capita basis, the main winners of a U.S. equalization policy would be Mississippi, Arkansas, and West Virginia. In terms of absolute payments, the largest beneficiary is by far Texas, accounting for approximately 15 percent of total equalization payments. The article considers arguments for and against adoption of an equalization policy and offers some preliminary comments on the politics of fiscal equalization in the U.S. context.

Keywords: federalism, decentralization, fiscal equalization, public finance, taxation

JEL Classification: H71, H73, H77