Do intergovernmental grants create ratchets in state and local taxes?

A large literature on the ‘flypaper effect’ examines how federal grants to states at time period t affect state spending (or taxes) at time period t. We explore the fundamentally different question of how federal grants at time period t affect state tax policy in the future. Federal grants often result in states creating new programs and hiring new employees, and when the federal funding is discontinued, these new state programs must either be discontinued or financed through increases in state own source taxes. Government programs tend to be difficult to cut, as goes Milton Friedman’s famous quote about nothing being as permanent as a temporary government program, suggesting that it is likely that temporary federal grants create permanent (future) ratchets in state taxes. Far from being purely an academic question, this argument is why South Carolina’s Governor Mark Sanford attempted to turn down federal stimulus monies for his state. We examine both the impact of federal grants on future state budgets and how federal and state grants affect future local government budgets. Our findings confirm that grants indeed result in future state and local tax increases of roughly 40 cents for every dollar in grant money received in prior years.