Crowding Out Development: Fiscal Federalism after the Great Recession

Abstract

Since the onset of the Great Recession, austerity has become more common at the national and local levels throughout the OECD. As states pass expenditure responsibilities down to the local level, this causes a shift toward mandatory spending at the local level which may undermine discretionary spending for social and physical infrastructure. We use Census of Government Finance data from 2012 for all county areas in the continental US to model the expenditure gap between current operations and capital investment, and show how this crowd out affects growth. Our structural equation models find fiscal decentralization has direct negative effects on local growth and indirect negative effects on growth by increasing the local current-capital expenditure gap. This local expenditure gap is larger where decentralization of spending responsibility is higher and state aid is lower, especially in places with greater need (poverty, older infrastructure, and rural areas). In contrast to the theoretical claims of fiscal efficiency, we find fiscal decentralization may be undermining local economic growth by increasing the gap between local current and capital expenditure. We argue that fiscal federalism (decentralization) is “broken” in the US because states have structural incentives to shift fiscal responsibility downward to local government, and local governments face increased social and economic need, especially since the Great Recession.