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December 18, 2019 – A new report by EPI Director of Research Josh Bivens examines how to make federal aid to state and local governments more transparent, effective, and responsive to recessions.

Bivens explains that in 2018, state and local governments alone spent roughly $2.8 trillion, or almost 14% of the U.S. gross domestic product (GDP), which accounted for well over one-third of all public spending in the United States. State and local governments are tasked with being the primary spender on crucial public investments, such as education and infrastructure, but face spending constraints that the federal government does not. Because of these constraints, a system of strong federal support for state and local governments has emerged over time. For example, in 2018, the federal government transferred almost $700 billion to state and local governments in direct grants. Additionally, the federal government also indirectly transfers potential fiscal resources to state and local governments by allowing some types of state and local taxes to be deducted from income for federal taxation. However, this “SALT deduction” cost the federal government $100 billion in 2017.

The Tax Cuts and Jobs Act (TCJA) of 2018 sharply limited the SALT deduction and increased the size of the standard deduction, inducing fewer people to claim the SALT deduction as a tax benefit. These changes reduced the overall cost of the SALT deduction to the federal government by roughly 80%, but the impact of the reduced SALT deduction on state and local governments’ ability to raise their own revenue and maintain spending is hard to predict.

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Bivens argues, however, the SALT deduction, like nearly every other tax expenditure (except for refundable tax credits) can, in theory, be substituted for with direct spending to meet targeted social goals more efficiently and progressively. Even the highest estimates of the SALT deductions pre-TCJA effects indicate that a 15% increase in federal grants to state and local governments would almost surely transfer more fiscal resources to state and local governments than the cap on SALT deductions have taken away from these subnational governments.

“The SALT deduction is one tool for redistributing tax revenue, but most working people don’t have access to it, because they don’t itemize their tax deductions to be able to qualify for it,” said Bivens. “We should transfer federal aid directly to states to allow them to use the money on targeted healthcare, infrastructure, and education spending, which would more progressively distribute the money and allow states to be more responsive to recessions.”

For example, the report finds that increasing the federal grant commitment to K–12 education through state and local grants could help undo the damage done by stagnant education spending over the past decade. Additionally, the federal government often provides some extra, temporary fiscal relief to state and local governments during recessions. These grants to programs like Medicaid can be modified to deliver aid more automatically when state economies slip into recession, providing a valuable tool to make the nation’s fiscal policy more responsive to downturns, and providing needed fiscal stimulus in a timely way.