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Disclaimer. Don't rely on these old notes in lieu of reading the literature, but they can jog your memory. As a grad student long ago, my peers and I collaborated to write and exchange summaries of political science research. I posted them to a wiki-style website. "Wikisum" is now dead but archived here. I cannot vouch for these notes' accuracy, nor can I say who wrote them.
Nicholson-Crotty, Sean. 2008. Fiscal Federalism and Tax Effort in the U.S. States. State Politics and Policy Quarterly 8 (summer): 109-126.
The federal government gives billions of dollars to the 50 state governments as grants-in-aid, whether to fund schools, Medicaid, or whatever. The idea is this: The federal government gives states extra money so that they will increase spending in a particular area without having to cut spending elsewhere. But is that what really happens?
Nicholson-Crotty presents evidence that it does not. Instead, he finds that states (indirectly) refund a significant proportion of federal funds to state taxpayers. When states receive money from the federal government, they use it to reduce state tax rates.
More precisely, Nicholson-Crotty finds that an increase in grant monies (X) leads to a decrease in the state's taxation effort (Y), a measure (from the Advisory Commission on Intergovernmental Relations) of the state's effective tax rate relative to the amount of money the state government could (hypothetically) tax. As X goes up, Y goes down.
This doesn't mean that states don't spend the money the way Congress wanted it spent. But it does mean that the states are cutting their own spending in the particular area, and possibly in other areas, keeping the state's overall spending somewhat constant despite the influx of federal funds.
Now, this relationship isn't perfect. Nicholson-Crotty considers three factors that might affect the extent to which federal monies simply get returned to state taxpayers.
As always, there are several control variables derived from previous work, such as partisanship, fiscal centralization, wealth within each state, urbanization, tax/spending limits, and election year effects.
And as always, there are a few methodological shortcomings in this article. Nicholson-Crotty addresses two--missing data and endogeneity--and applies reasonable remedies. The endogeneity issue is interesting; federal money is most likely to go to those states that are most likely to spend it--that is, to liberal states.
A third, which he does not discuss, is that his first intermediate variable (grant type) does not vary sufficiently. He examines only matching grants. Although the level of matching varies (from $.50 on the dollar to $.77), I would like to see more variance here. This is a bigger oversight than you might think. Given NIcholson-Crotty's findings, members of Congress might like to know what they can do to minimize the problem and ensure that federal grants have the intended effects. An easy solution implied by the article is to switch from block grants to matching grants with a highly elastic matching rate--but this article does not directly tell us how much we can gain from such a change.
The political implications of this study are broader than the author seems to realize. To see why, consider these two points from the article:
Putting it all together, Nicholson-Crotty is telling us that federal grants-in-aid are little more than a redistribution of the income tax burden from liberal states to conservative ones. No wonder Republicans have been so interested in their "devolution revolution."
For other views on the "devolution revolution," see here and here.
Research on similar subjects
Nicholson-Crotty, Sean (author) • American Politics • Budgets and Fiscal Policy • Federalism • State Politics (U.S.) • State Politics and Policy Quarterly • Taxes
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