Evidence of serious problems in the American intergovernmental system is everywhere. Senator Lamar Alexander (R-Ten.) recently called for an exchange by the federal and state governments of responsibilities for education and health policy to solve critical state financial problems. News stories report municipal bankruptcies and that state and local governments have laid off more than 700,000 employees during the past two years.

The State Budget Crisis Task Force, co-chaired by former Federal Reserve Chairman Paul Volcker and former New York Lt. Gov. Richard Ravitch (D), documents serious long-term issues. The Government Accountability Office (GAO) has found that state and local revenues have shrunk to the point that federal grants represent a bigger percentage of total revenue than any single self-raised tax revenue source. Those same governments' healthcare expenditures will ultimately become almost 50 percent of their budgets.

Nevertheless, it took the Supreme Court's recent highly publicized decisions on immigration and healthcare to remind Americans that no individual governmental institution—or set of institutional relationships—is more important to effective public policy making and government service delivery than our complex intergovernmental system.

The Intergovernmental System Faces Multiple Challenges

The contemporary intergovernmental system faces numerous administrative, political, and fiscal challenges. The administrative challenges involve both short- and long-term issues. Short-term issues include coping with the increased service demands and the dramatic personnel reductions due to a weak economy. Longer term is the challenge of attracting and retaining a qualified public-sector workforce. This is exacerbated by the reductions in salary, health, and pension benefits that have demoralized state and local employees.

In addition, the decline of institutions with expertise on intergovernmental issues has diminished the system's capacity for sound decision making on policy and management issues. Plus, partisan polarization is crippling the nation's ability to deal with budget, economic, and social issues, and sometimes even meet basic policy responsibilities.

It is widely recognized that there is a mismatch between current revenues and citizens' demands for public services at all three levels of government in the United States. Numerous studies suggest the problems will become worse in the absence of significant action. What is often not recognized is that these situations are interrelated across all three levels of government. The country will face an intergovernmental revenue crisis if it does not address its fiscal problems from an intergovernmental perspective.

As they face up to these challenges, the nation's governments have three choices: go it alone, engage in fiscal offloading to other governments, or enter a new era of institutional and fiscal collaboration. For example, Washington's block grant proposals for Medicaid would constitute a massive cost shift to states unless they found ways to cut payments to doctors, dramatically reduce services, or reduce the number of clients. A go-it-alone approach by each level of government will make the hard fiscal choices that much harder. 

In another example, federal tax cuts materially affect the revenues available to the vast majority of states, whose income taxes are linked to the federal tax code. The estate tax cut and phase out in 2001 opened a large revenue hole for many states that for decades had relied on a cooperative federal-state framework to enforce the state portion of the estate tax. Conversely, state staff cuts have adversely affected such federal programs as disability determinations for social security; these programs rely on states to help evaluate actions, a classic cooperative federalism program that is undermined by unilateral budget cuts.

When all governments in our federal system suffer from common maladies, joint solutions are preferable. Through fiscal collaboration, governments can join together in developing solutions. One example of how such a process of fiscal collaboration might produce win-win outcomes involves a consumption tax, or a value added tax (VAT). The United States is one of the lowest taxing nations, and the only major industrial nation without a national consumption tax. Compared with state sales taxes, a VAT has several advantages, including a national and international reach into the service economy, and revenue potential that could fill fiscal gaps at all levels of government.

Absent an intergovernmental partnership, the danger to the states from a national consumption tax is very real. A federal government desperate to solve its own deficits could enact a consumption tax unilaterally that would undermine state sales taxes. However, as Australia has shown, a national government can adopt such a tax with state and local governments sharing in the gains. States can piggyback on the expansive national consumption tax base, replacing their own declining sales taxes with a far more productive tax. An intergovernmental dialogue and a real policy-making partnership could lead to adoption of consumption tax legislation that satisfies the fiscal interests of the entire public sector.

The Current Outlook Is Dim

Notwithstanding the benefits of collaboration, our collective capacity to work together to develop common policies across our federal system has sunk to record lows. In 1980, at the federal level, the following institutions existed for the purpose of addressing intergovernmental conflict:

  • Advisory Commission on Intergovernmental Relations
  • OMB Division of Federal Assistance
  • House and Senate Subcommittees on Intergovernmental Relations
  • GAO Unit on Intergovernmental Relations
  • Congressional Budget Office state and local cost estimates unit.

Today, only the last two exist. The White House does have an intergovernmental liaison office, but its purpose is to gain short-term political support from state and local officials.

State and local governments' capacity to work proactively with federal officials also has been weakened. Their interest groups in Washington are increasingly plagued by divisive polarization among their members, which undermines their ability even to take positions on such measures as health reform or other important legislation affecting the federal system. This is in distinct contrast to other nations' federal systems.

Australia has quarterly meetings between national and state leaders, while Canada has semiannual conferences among these officials. While American presidents, governors, and mayors frequently meet, rarely do they focus on the role that our federal system plays in making this country work.

Comprehensive Federalism Reform Is Needed

The scale of challenges has spurred renewed interest in comprehensive policy reforms that will affect the federal system. Some initiatives focus on the intergovernmental system itself, as does former Federal Reserve Vice Chairwoman Alice Rivlin's renewed call to sort out of functional responsibilities and revenues between the national government and the states.

Similarly, many proposals for comprehensive federal tax reform bear significant implications for state and local finance. Most plans anticipate reducing or eliminating the federal deduction for state and local taxes as part of a larger strategy of broadening the federal tax base, and many anticipate eliminating the exclusion on interest on state and local bonds.

These and other tax law changes would erode state and local governments' capacity to finance their own responsibilities. Reform proposals such as these involve complex issues of governmental finance, administrative capacity, and political viability. But, they also involve core values in our political system. Many would significantly alter the intergovernmental system's capacity for assuring equal opportunities for all citizens, encouraging state and local innovation, and being responsive to the preferences of local constituencies.

First Steps in Reforms to Strengthen the Federal System

To strengthen the federal system's capacity to address emerging needs for public services and government budget deficits, intergovernmental tax reform should be undertaken in a collaborative manner; a means to an institutional framework for the improvement of intergovernmental policy must be initiated; and, work must be done to rationalize the system.

  • Both needs for public services and long-term deficits must be addressed. While the nation's intergovernmental crisis has many dimensions, at its heart is the absence of adequate revenue to support needed public services. For example, a recent study by the Organisation for Economic Cooperation and Development (OECD) points out that 30 years ago, the United States led the world in the percentage of 25 to 34 year-olds possessing the equivalent of at least a two-year degree. Recent data show that the United States now lags behind 14 other countries in that measure of human resource capacity. Similarly, 20 countries now have higher high school graduation rates than the United States. Nevertheless, states and localities in most parts of the country have been disinvesting in their educational systems, and in many cases, significantly so.

    While there are many explanatory factors, the most important one is the absence of adequate revenues. The Rockefeller Institute reports that state tax collections dropped by more than 16 percent in just one quarter of 2009, and were barely at 2006 levels by the end of 2010. As the Pew Center on the States has noted, local governments are experiencing the simultaneous decline of both state aid and property taxes for the first time since 1980. The recession has had parallel effects on federal revenues, which sunk to 15.1 percent of GDP—a level not seen since 1951. Because these declines have had significant impacts on both public services and debt, major tax reform is essential to address both emerging needs for public services as well as long-term deficits at all levels of government.
  • Tax reform must be undertaken in a collaborative manner. There is a need for a national tax reform initiative that should include federal, state, and local governments. While recent federal budget commissions have called for federal tax reform to simplify the tax code and raise revenue, such an effort could lead to further erosion of fiscal capacity of the state and local partners in our federal system.

    A national intergovernmental tax reform initiative would be far more effective in giving serious consideration to important new revenue systems such as a national consumption tax. As other OECD nations have shown, a national consumption tax along the lines of a value-added tax could provide significant advantages for the national economy both in terms of additional revenues and savings incentives. However, given the states' substantial investment in sales taxation, only an intergovernmental tax reform process can gain the support of states that will be critical to implementing much needed reforms.
  • Create an intergovernmental policy council. The president should initiate an intergovernmental policy council that is adequately staffed and meets at regular (at least quarterly) intervals to review, assess, and advise on initiatives designed to enhance the American intergovernmental system. It should be bipartisan in nature. Half of its members should be appointed from the federal level of government, by the president and by the party leaders of the two houses of Congress.

    Its other membership should consist of governors, mayors, or other elected local government officials. There should be two ex-officio nonvoting members drawn from the executive directors of the seven major state and local governmental associations. The council should undertake the ongoing assessment of programs which involve federal government participation, and are implemented by state and local governments. It should also address the strengths and weaknesses of the intergovernmental system, and in particular, the adequacy of the resources to achieve desired policy outcomes.
  • Address reform of the grant system and personnel needs. The Intergovernmental Policy Council should immediately address various issues central to the effectiveness of the intergovernmental system. Toward that end, it should appoint working groups composed equally of national, state, and local officials to address:
    • grant reforms (such as program consolidation, improved grant management practice, and block grants) to simplify an increasingly complex system characterized by more than 900 separate categorical grants
    • human resource policy reforms to cope with the loss of experienced professionals in the public service and the effects of demographic change on service demands and public pension systems.