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Revenue Sharing for the States: How It Works, Why We Need It, and Why Nixon Liked It

Our policymakers continue to believe that they must first 'get credit flowing again' to restore output and employment. Unfortunately the reverse is the case.
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Cross-posted from New Deal 2.0.

Our policymakers continue to believe that they must first 'get credit flowing again' to restore output and employment. Unfortunately the reverse is the case: restoring output and employment will restore the flow of credit. Creditworthiness precedes credit.

And yet, as we get closer and closer to D-Day on the debt ceiling limit, the negotiations continue to turn on how much income the government should drain from the economy, even as private sector activity continues to stagnate. All moves to date by the Treasury and Federal Reserve have only served to shift financial assets between the public and private sectors. And that includes quantitative easing. Nothing has directly added to aggregate demand (the overall demand for goods and services).

The economy has therefore continued to deteriorate, with only the 'automatic stabilizers' like unemployment insurance slowly adding financial assets and income to the private sector as the counter-cyclical deficit rises. The rate of federal deficit spending now exceeds around 8% of GDP and seems to have begun moving the economy sideways, but has been insufficient to offset the impacts of the worst recession in over 70 years. Indeed, the combination of a tepid fiscal response -- which appears to have been just enough to ward off a second Great Depression -- and the premature fiscal withdrawal are largely to blame for the weak and teetering recovery.

Worst of all, most of the fiscal packages have been spent. That suggests that in spite of all of the cheerleading by US officialdom and the beneficiaries of this Potemkin prosperity, we will not record significant gains in employment until real output of goods and services exceeds productivity growth. Withdrawal of yet more fiscal stimulus, as the mainstream "experts" (who completely missed the Great Recession of 2008!) continue their call for further cutbacks in government spending, risks a repeat of the error that FDR made when he listened to conservative economic advisers in 1937. He slashed the budget deficit during the Great Depression -- causing a renewed surge in unemployment and the extension of the depression.

The most immediate crisis, deserving attention before any other, is in the states and cities. Yet assistance to the states is being cut off at a time likely to forestall economic recovery. State and local budgets should not be cut. But how to prevent this? Here's an idea: By recreating a revenue sharing program for the states, with a pass-through to cities, on a scale sufficient to plug the budget gaps. How much is needed? As James Galbraith
, the federal government's fiscal aid to the states has hitherto only offset the job cuts imposed by falling revenues and balanced budget requirements. He therefore suggests a number of practical measures to enhance this revenue sharing:

Federalizing Medicaid may be the most effective and practical way to achieve this. The alternative is open-ended general revenue sharing: on the condition that states neither raise nor lower their tax rates, the federal government should supply the funds required to close their budget gaps and to maintain public services at baseline levels, for the duration of the crisis.

President Obama could well point out that revenue sharing has Republican lineage; it ought to be a bipartisan cause today. It was Richard Nixon who first introduced the concept. Nixon viewed the federal bureaucracy as a poor revenue manager and argued that much counter-cyclical spending should go to the states, as they are closer to people's needs and more directly hurt by falling revenues. But instead of simply cutting taxes, as later conservatives would, he proposed a new system called revenue sharing, which redirected funds to states and municipalities. The federal government would collect taxes and local governments would spend the money. Passed after contentious debate, the State and Local Assistance Act of 1972 initially delivered $4 billion per year in matching funds to states and municipalities. The program, which distributed some $83 billion dollars before it was killed by Ronald Reagan in 1986, proved enormously popular.

It is important to remember that a sovereign government with its own currency can always financially afford such a program. By virtue of its position as issuer of the currency, the US Federal government could promote employment, output, income, and private expenditure through the expedient of revenue sharing. By contrast, US states, as users of currency, are reliant on this counter-cyclical fiscal policy to mitigate the destructive effects of economic downturns -- particularly unemployment and the suffering it causes. In the words of Erik Dean, the states "cannot run budget deficits without risking credit downgrades and insolvency. Recessions typically diminish revenues for these users of the currency at the very time that their expenditures are most needed."

As an example, consider Hurricane Katrina. True, the rescue package was marred by incompetence, but how was New Orleans able to rebuild, given the underlying financial condition of the state of Louisiana? Simple, as David McWilliams
in today's UK paper, "The Independent":

The United States cavalry rode in to save New Orleans and the State of Louisiana. The President declared a state of emergency, Treasury wrote the cheques and the Federal Reserve credited Louisiana's accounts. They then spent those dollars on cleaning up the city. So the central bank credited the account of the State of Louisiana because emergency economic conditions meant the State needed it. The State issued no bonds; there were no IOUs, except that the deficit of the US rose. There was no effect on inflation.

Yes, we have recovered from the worst of the crisis. But it is delusional to believe that economic recovery can really get underway until we have added something close to 10 million jobs. The current level of job growth will not see us get anywhere near that target for at least another 3-4 years. Indeed, in the absence of revenue sharing, we are likely to see more attacks on workers of the kind that has characterized recent budget battles in Wisconsin and Michigan. Wall Street crashed their pensions and created the fiscal crisis now afflicting the states. But this administration is still caught in the grips of that failed economic paradigm. If President Obama were to fight for revenue sharing, he would develop tens of thousands of local government allies. He would also have a very powerful issue with which to fight the next election, as well as a winning economic argument.