Section A: POSSIBILITIES AND PROBLEMS

FEDERAL TAX SHARING: HISTORICAL DEVELOPMENT AND ARGUMENTS FOR AND AGAINST RECENT PROPOSALS

BY MAUREEN MCBREEN*

INTRODUCTION

There has been considerable agitation during the past 3 years for enactment of legislation which will channel some portion of Federal tax revenues to State and local governments with a minimum of Federal supervision and control.

This idea of Federal tax sharing with State and local governments actually is not new, but it has only recently received widespread public attention.

TAX SHARING ADVOCATED BY THE DEMOCRATIC ADMINISTRATION

One of the leading proponents of such a proposal has been Dr. Walter W. Heller, former Chairman of the President's Council of Economic Advisers. In June 1960, while still chairman of the Economics Department of the University of Minnesota, he proposed that rising Federal revenues be distributed to State and local governments with few or no string attached.1

This proposal did not begin to receive serious consideration until the spring of 1964. Earlier in the year, the Revenue Act of 1964 had been signed into law, and administration leaders were hopeful that the substantial reductions in income tax rates provided by this law would give the American economy the additional stimulus which was needed to enable it to operate at close to maximum productive capacity. At that time, the prospects of achieving Federal budgetary surpluses in the next few years appeared quite hopeful, and it was felt that serious attention could now be focused on this tax-sharing proposal as a means of alleviating the financial plight of many State and local governments.

The Democratic Party platform adopted in the summer of 1964 specifically recommended that the Federal Government should give consideration to the "development of fiscal policies which would provide revenue sources to hard-pressed State and local governments to assist them with their responsibilities."

During the election campaign which followed during the fall of 1964, both presidential nominees voiced their general support of this

*Analyst in Taxation and Fiscal Policy, Economics Division, Legislative Reference Service, The Library of Congress, Washington, D.C. Jan. 30, 1967. 1 For a detailed description of Dr. Heller's proposal, see p. 718 ff.

proposal. President Johnson declared the intention of the administration to carry out the pledge the Democratic Party had made to seek ways and means of providing additional financial assistance to State and local governments. As a means of carrying out this intention he proposed that the Federal Government make available to State and local governments "some part of our great and growing Federal tax revenues-over and above existing aids." The Republician nominee, Barry Goldwater, recommended that a portion of Federal income taxes be returned to the States, and that State governments be given a larger share of revenues derived from inheritance taxes.

PRESIDENTIAL TASK FORCE STUDIES PROPOSAL

President Johnson then appointed a task force composed of individuals from government and business and headed by Dr. Joseph A. Pechman, Director of Economics at the Brookings Institution, to study the possibility of setting aside a fixed percentage of Federal revenues each year in a trust fund for distribution to State and local governments. A report was subsequently made by this task force and submitted to the White House, but the full details of its recommendations were never made public.

Two basic considerations prompted the Democratic administration to consider in 1964 the possibility of sharing additional Federal revenues with State and local governments over and above assistance already available under existing Federal grants-in-aid.

First of all, the steady growth of the gross national product and the expectation of a continued upsurge in our economy led many optimistically to predict that by 1966, and in the years immediately following, a Federal budgetary surplus would be achieved. While these surpluses were to be welcomed, there was some apprehension among administration economists that the realization of these surpluses before full employment of manpower and resources was achieved would cause a "fiscal drag" on our economy and would retard the business expansion which was underway.

The second underlying factor was the general widespread belief that State and local governments were badly in need of new revenue sources to meet the ever-growing requirements of their rapidly expanding population for additional schools, hospitals, and health and welfare services. With tax systems which place heavy reliance on sales taxes, fees, and property taxes rather than taxes on incomes, State and local governments are finding it increasingly difficult with each passing year to find adequate revenues to finance the rising costs of these programs considered vital to the well being of their citizens.

While, as noted above, the findings of the Presidential task force have never been officially released, it is understood that a formula was recommended which would provide that 1 or 2 percent of the Federal personal income tax base (which is taxable income after exemptions and deductions) would be set aside annually in a trust fund for distribution to State and local governments. Thus, assuming, for example, a tax base of $250 billion, State and local governments would

2 Presidential Statement No. 6 On Economic Issues. Strengthening State-Local Government, Oct. 28, 1964.

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receive anywhere from $2.5 to $5 billion annually should such a formula be adopted. As the economy expanded and Federal revenues rose, more would automatically become available for allocation to State and local governments under this plan.

Supposedly these block grants were to be given to the States unconditionally. This means that State and local governments would be free to make their own determination on just how the money would be spent. Also, there would be a minimum of Federal supervision over the expenditure of these funds once they were disbursed to the States.

It is reported that the task force recommended that perhaps a relatively small proportion of the total payments be distributed on the basis of per capita income and the remainder on a population basis. These amounts would be in addition to payments which are already made under the many existing programs of Federal aid, some of which have been in operation for years. During the current fiscal year, 1967, such payments to State and local governments are expected to amount to $15.4 billion. They are disbursed for specific purposes such as for highway construction, airport construction, school construction and maintenance, public assistance and for a wide variety of welfarerelated programs. They are allocated under varying formulas prescribed by law. These formulas frequently require State matching, and many have been so devised that the poorer States receive relatively more aid than the richer States. Each program is subject to close supervision and control by the administering Federal agency. During the fiscal year 1966 Federal grants-in-aid constituted 15.6 percent of State and local government revenue.

HISTORICAL PRECEDENT FOR FEDERAL TAX SHARING

A. UNITED STATES EXPERIENCE

As is noted above, Federal revenue sharing with State and local governments is not new. For many years the U.S. Government has shared some percentage of revenues derived from the sale of Federal public lands, from grazing leases and permits, from the use of national grasslands, and so forth, with State and local government. In some instances no specific purpose is prescribed by law on the use of these shared revenues; in others, they are restricted to use for specified purposes, such as public education, roads or other internal improvements.

One historic precedent for the distribution of Federal surplus funds among the States on an unconditional basis was the Surplus Distribution Act of 1836. During the administration of President Andrew Jackson, a large Federal surplus had accumulated as a result of substantial revenues received from the sale of public lands and from customs receipts derived from an expanding foreign trade. The public debt had been virtually eliminated, and so this legislation was enacted which provided that all money in the Treasury on January 1, 1837, with the exception of $5 million, should be deposited with the States in proportion to their respective representation in the Senate and in the House of Representatives. These deposits were to be made in four installments on January 1, April 1, July 1, and October 1. In return

for these deposits the Secretary of the Treasury received certificates from the States which pledged that they would keep and repay the money as might be required by the Secretary of the Treasury from time to time.

Of the $37 million available for distribution, $28 million was actually deposited with the States in three installments. A financial crisis arose during the latter half of 1837, and the fourth installment was never made. Although these funds were extended only as a loan, which was subject to repayment, actually the distribution was generally considered as an outright gift, and none of the money was ever requested or returned. This act did not specify what use the States might make of these funds, but a large number of the States spent some portion of their allotment for educational purposes. Others used the money to pay current expenses, to reduce State indebtedness, to build roads, bridges, canals, or to make other internal improvements. The State of Maine made a per capita distribution of its share of the money received. ' At the State and focal level, the sharing of State tax revenues with local units is a common and widespread practice.

B. FOREIGN EXPERIENCE

Canada, Australia, Western Germany and Argentina have varying arrangements of sharing tax revenues with local governing bodies.

PRESENT ADMINISTRATION STAND ON TAX SHARING

The Democratic administration has now shelved, at least for the time being, this proposal for Federal tax sharing with State and local governments. Undoubtedly, the fiscal impact of acceleration of the war in Vietnam has been a primary factor in influencing the President to postpone making any specific legislative recommendation for adoption of some form of Federal tax sharing. Further, the administration prefers to rely on established programs of grants-in-aid. There is, reportedly, strong opposition within Government to such a proposal which would allocate Federal funds to political units with little or no strings attached. President Johnson, in his state of the Union message delivered at the convening of the 90th Congress on January 10, 1967, emphasized the extensive Federal assistance which is already being provided to State and local governments. He reported that “during the past 3 years we have returned to State and local governments about $40 billion in Federal aid. This year alone, 70 percent of our Federal expenditures for domestic social programs will be distributed by State and local governments."

THE HELLER PROPOSAL

Dr. Heller, in his latest book, New Dimensions of Political Economy, spells out in detail his Federal tax-sharing proposal. In essence, he would set aside in a trust fund 1 to 2 percent of the Federal individual income tax base (the amount reported as net taxable income

Heller, Walter W. New Dimensions of Political Economy. The Godkin lectures at Harvard University. Cambridge, Mass., Harvard University Press, 1966. 203 pages.

by individuals). He estimates that a 2-percent rate applied to the 1966 tax base would yield some $5.6 billion for the State and local govern

ments.

He believes that taxable income is superior to actual income taxes collected in determining the amount set aside for distribution to the States. He offers the following reasons for this opinion:

First, taxable income is somewhat more stable than revenues. Second, since the States' share would be independent of the level and structure of Federal rates, this approach would not create a vested interest in a particular set of rates (though it might do so in exemption levels). Third, for the same reason, it is less likely to interfere with Federal use of the income tax in stabilization policy than a plan keyed to income tax revenues.*

His plan would call for a per capita sharing among the States of the amounts set aside in this trust fund. A per capita distribution was deemed preferable to sharing on the basis of origin of tax collections as the former would allocate the funds more on the basis of need, whereas the latter would return more to the higher-income, higher revenue-producing States and correspondingly less to the poorer States.

He also recommended that if a greater measure of fiscal equalization is deemed advisable than would be available by using only a per capita distribution, then perhaps from 10 to 20 percent of the total amount might be allocated on the basis of per capita income.

A trust fund was suggested as it would make the funds available to the States "as a matter of right, free from the uncertainties and hazards of the annual appropriation process." This device, he felt, would also be less apt to infringe on the flow of grants-in-aid.

These block grants would be over and above amounts already received by State and local governments under the many existing Federal grant-in-aid programs. Furthermore, they would be available automatically from year to year and would not be contingent on the realization of a Federal budgetary surplus. In this way State and local governments would have a continuing and a dependable source of income and could plan their programs without fear that this revenue source might suddenly be withdrawn.

Dr. Heller advocates that the States be given almost complete freedom in the use of these funds. He does ask, however, that the States meet the usual standards required in accounting, auditing, and reporting the expenditure of public money. He further stressed the importance of using the revenues shared in such a way as not to violate title VI of the Civil Rights Act of 1964 which prohibits racial discrimination in federally financed programs. He indicated that it might be deemed advisable to restrict expenditure of these grants to education, welfare and community development programs, or at least, to prohibit their use for highway purposes.

Dr. Heller has not proposed that his plan be put into effect immediately, but he has urged that a plan be fully developed and put into action just as soon as the Vietnamese conflict is resolved.

Ibid., p. 146.

Heller. Op. cit., p. 146.