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The Role of the State in the Economy

Professors Cecilia Testa discusses federalism and the role of the state in the economy from an economic perspective.
Alexander Hamilton advocated a strong, unitary national government, where states would only have limited powers. However, states had historically well defined and distinct identities. They had their own established government institution and loyal citizens. In the 18th century, people of North America were not Americans. They identified with their own states. As a result, the federal structure was more appropriate to bring together individual states into a unitary national entity, the United States of America. Federalism is, indeed, one of America’s most important institutional features. What is Federalism? Federalism can be defined as the division of powers and functions between national government and state governments. For example, the national government has the power to collect taxes, coin money, regulate commerce, and declare war.
State governments have the power to develop and enforce criminal codes, regulate family via marriage and divorce laws, regulate individual profession by issuing licences, and so on. In several instances, powers are shared between national governments and states. For example, both have the power to raise revenue and spend it to publicly provide goods and services. What are the advantages and disadvantages of centralisation as opposed to devolution of powers? The central government, maximising the joint interests of all members of a federation, is able to take into account the decision taken at state or local level, may have effects that go beyond the border of a particular state or locality.
For example, a polluting activity generating economic benefits in a given state, may raise pollution also among neighbouring states, that would bear the cost of pollution without its economic benefits. This is an example of negative externality. Externalities, of course, can be positive, too. More generally, the prohibition of certain goods and services may have negative or positive spillovers, which imply that local government may under provide or over provide such goods and services, because they do not take into account the benefit or cost they entail outside their community. A central government, by taking into account externalities, is able to address this problem, and provide the amount of goods and services that maximises social welfare. However, decentralisation has other benefits.
For example, local governments have better information on local needs and citizens’ preferences. The proximity to users of services also implies that citizens may better monitor and keep elected officials accountable. Thus, US federalism, by allocating different powers to national and state governments, tries to strike a balance between the benefits of decentralisation and those of devolution. Although the US Constitution sets out the boundaries to the powers of national and state governments, the balance of power between federal government and the members of the federation has changed substantially over time. Before the ’30s, during the so-called period of dual federalism, the role of national government remained limited.
For example, the power of federal government to tax income was only established by the 16th amendment to the US Constitution in 1913. In the ’30s, with the New Deal, the role of federal government became much more prominent. In particular, federal subsidisation of state and local activities via the so-called grants and aid became a permanent feature of the US public finances. Federal grants and aid are transferred to state governments that are used to finance essential services, such as education, policing, health care, and so on. They are an important source of state revenue. Although the majority of state spending is financed by old revenues, nowadays over 1/3 of the state budget is represented by federal transfers.
For example, between 2000 and 2008, federal aid amounted to about 25% of the state’s budget. Substantially more than in the ’50s, where only 16% of state resources came from federal government. How do the different states fare in the allocation of the federal budget? In per capita terms, the amount of federal grants in aid received by the states varies substantially. For example, between 1978 and 2008, small Wyoming received on average $1,136 per capita, almost three times the amount received by large Florida. More generally, the relationship between federal spending and population size seems to follow a systematic pattern. Less populous states receive more spending in per capita terms than more populous ones.
This is often interpreted as evidence of a small state advantage in the allocation of the federal budget, stemming from the fact that small states are overrepresented in the US Senate. The principle of equal representation mandates that every us state, independently of its population size, elects two senators. Why overrepresentation in the Senate might play some role, a much more plausible explanation from disparity and allocation between large and small states is simply given by economies of scale in the provision of goods and services. Public spending is often used to finance projects, such as infrastructure, with a substantial fixed cost component. As a result, in per capita term, the cost of providing the same infrastructure is substantially lower in more populated areas.
Moreover, if we analyse the way in which spending tracks population over time, another interesting pattern emerges. States whose population grows faster see per capita spending decline independently of whether they are large or small. For example, small Nevada, whose population grew rapidly between 1978 and 2008, did not experience an increase in federal transfers proportionate to its population dynamics. This no growth in federal spending in small Nevada is very similar to pattern we observe in large states with fast growing populations, such as Florida or California. Why do fast growing states lose out in the allocation of federal spending? Federal aid to the states is largely administered by formulas legislated in Congress that make it difficult to adjust spending to rapidly changing needs.
Between 1983 and 2008, spending on formula grants amounted on average to 70% of total federal aid. This includes the two largest federal programmes, Medicaid and the Federal Highway programme, representing respectively 45% and 50% of grants allocated by formula during the same period. As a result, states with a fast growing population tend to be penalised in the distribution of federal grants that are allocated to a large extent by formula. Ironically, why these funding formulas are typically put in place to reduce discretionary and political manipulation in the allocation of the federal budget, they often become a powerful tool to keep in place a status quo allocation that is favourable to a majority of states.
This highlights fact illustrates a more general problem in centralising spending decisions. Although the national government should allocate resources across states to maximise total welfare, in practise the allocation of the federal budget is the outcome of a political process, where sometimes local needs do not receive adequate consideration.

Alexander Hamilton advocated a strong unitary national government where states would only have limited powers. However, federalism was the more appropriate structure to bring the individual states together as one into the United States of America. Federalism is defined as the division of powers and functions between national government and state governments.

Professors Cecilia Testa discusses how federalism functions in the America. She compares both centralization and decentralization looking at their advantages and disadvantages. Cecilia also comments on how the balance of power between the federal and state governments has changed over time.

In the comments below, discuss where you think the balance of power should lie within a country. Do you believe that either centralization or decentralization of power is the better than the other? Why do you think so?

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The Politics of Economics and the Economics of Politicians

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