The United States is supposed to be a federal country, in which state governments enjoy exclusive authority to decide on policies not delegated to the central government, including policies on taxes and spending. Federalism is supposed to have many advantages: it allows state governments to experiment with policies and copy the most successful ones from each other, and it allows citizens to “vote with their feet” by moving to states whose policies they prefer.
But critics of federalism point to one big disadvantage: federalism, they say, is unfair.
In this view, federalism is unfair because it helps the residents of rich states and hurts the residents of poor ones.”]
This criticism particularly applies to the fiscal aspect of federalism — that is, the ability of states to choose their own tax burdens and spending levels. The argument runs like this: states have different tax bases per citizen (some are richer than others), so richer states can tax their citizens at lower rates than poorer states, offer more benefits and better public services, or both. In this view, federalism is unfair because it helps the residents of rich states and hurts the residents of poor ones.
I will argue, by contrast, that fiscal federalism actually helps people living in poor states more than people living in rich states.
Fiscal Equalization Programs
Even some scholars sympathetic to federalism acknowledge the force of the argument about fairness. Wellesley sociologist Josh McCabe argues that fiscal equalization programs are necessary to build political support for “highly decentralized federalism,” because without them, richer states will always be able to tax at lower rates and fund public services at higher levels than poorer states.
Now, one major disadvantage of equalization in a federal system is that it discourages states from letting their populations become rich. This is clearly true of Germany’s equalization system, which completely equalizes tax bases and even per capita spending levels across the Laender (states). As the economists Thomas Döring and Stefan Voigt put it, “The benefits and costs of political decisions no longer accrue at the same level” in Germany. So the state governments in Germany can feel free to give special interests the regulations they want without fear of deterring investment and reducing revenues.
Equalization through Migration
But there’s a more fundamental problem with the fairness argument for equalization: it ignores migration.”]
But there’s a more fundamental problem with the fairness argument for equalization: it ignores migration. Presumably, we care about the welfare of actual people, not the arbitrary geographic categories they live in. In a federal system in which people can easily move across state borders, migration accomplishes everything an equalization program might, without the negative side effects.
Think about a positive productivity shock, like the emergence of a new, highly profitable industry, which raises real wages in one state. Workers will move from other states to the state with the higher wages. The increase in the labor supply will return real wages to their normal level, at which point the migration flow will stop. Those who have moved have become better off, and even those who have remained in the initially poorer states are, at the end of the day, earning just as much as those in the initially richer state. Being able to pay a lower tax rate in a richer state will only accelerate this process — and ultimately eliminate the rich-state tax advantage.
So why don’t wages equalize across US states today? Two reasons. First, some places are just more desirable to live in than others. These places will tend to have higher home prices and rents and lower wages. Think about it: if I take some of my compensation in the form of higher amenities, I’m willing to earn a lower real money wage. For this reason, nice places to live that don’t have a lot of industry, like New Mexico and Maine, have low real wages, while places that are less nice to live in but do have industry tend to have high real wages (see figure 1).
But New Mexico and Maine residents surely don’t deserve to be subsidized simply because they prefer to take their compensation in a nonpecuniary form, just as North Dakotans and Bay Staters don’t deserve to be taxed for choosing to live in unpleasant places where the market demands their labor.
Figure 1: Real Per Capita Income by State, 2015
Source: Bureau of Economic Analysis.
Second, some places more strictly regulate housing development than others. States with tight development rules end up with a high cost of living and high per capita income, because low- and middle-income households move away from these states, not being able to afford to live there (see figures 2 and 3).
Figure 2: Residential Building Restrictions Raise the Cost of Living
Sources: BEA, Wharton Residential Land Use Regulatory Index (WRLURI)
Figure 3: Residential Building Restrictions Raise Nominal per Capita Income
Certainly, housing regulation is disrupting equalization through migration in the United States. An equalization program that specifically punished costly states and rewarded low-cost states might discourage excessive development restrictions and get migration flowing more freely again.
But housing regulation might end up being a self-correcting problem. As people flow from high-cost to low-cost areas, eventually the latter will enjoy more agglomeration economies that promote economic growth, and the high-cost areas will start to falter by comparison. By regulating housing so strictly, residents of coastal California, the Boston metro area, and elsewhere may be digging their own graves in the long run.
Not so unfair after all
So long as there’s a common market, federalism is fully consistent with converging incomes across geographies and does not benefit people living in rich places above those living in poor places. Just look at the European Union, where Ireland managed to achieve astounding growth rates beginning in the 1980s, despite initially lagging behind. The EU does have a small equalization program, but it’s not enough to significantly discourage member states from trying to attract investment. The most significant aspect of the EU is the common market that allows workers and investments to flow across borders. In a paper in Regional Studies, I found that the EU achieved even more convergence in per capita incomes after 1986 than did the United States and Canada!
It can be difficult to explain to people how fiscal decentralization actually benefits people living in poor states, so there will always be political demands for equalization programs. But the evidence suggests that “unfairness” is an unfair reason to oppose federalism.
 It wouldn’t accelerate this process if states depended primarily on taxes on investment, rather than labor, for revenue. But in fact, only Alaska derives a significant share of its state budget from taxes on capital investment.