Time for a New Fiscal Federalism: Three reforms deserve attention.

• Author: Dailami, Mansoor

American fiscal federalism, a novel political innovation of the founding era, continues to inspire and intrigue policymakers and scholars after close to two-and-a-half centuries. Europe is now invoking a "Hamiltonian moment" to create an $858 billion recovery fund to rescue EU economies from the ravages of the Covid-19 pandemic, with the money to be raised on the capital markets on behalf of the Union and disbursed to member countries as loans and grants. Meanwhile, in America itself, federalism has become a watchword in the politics of Congressional debate and partisan rift over the pandemic response, rendered more dramatic by the severe budget crises overwhelming state governments. As of this writing, negotiations over a new stimulus plan have reached an impasse, even as state governments brace for deeper budgetary cuts.

More consequential for the states' ability to hold the line in the battle against the pandemic is the inherent irony in the functioning of American fiscal federalism. Even while state power is protected by the U.S. Constitution through the Tenth Amendment, and state interest is held up by the forces of national politics ("political safeguards of federalism") and by judiciary intervention, states are not vested with the necessary fiscal power to safeguard their finances from business cycle fluctuations or shocks from extreme events, such as a pandemic or a natural disaster.

One key drawback of current fiscal federalism is the "fiscal mismatch" in state-federal relations that leaves states with procyclical tax revenues, but countercyclical spending obligations. The other relates to states' own balanced budget and debt rules that arose from state defaults in the 1840s and the tax revolts of 1970s but continue today to limit their ability to borrow and run deficits.

The burdens on state budgets have been considerable volatility and periodic crises. Following the 2008 global financial crisis, state governments faced a cumulative budget shortfall of $690 billion spread over fiscal years 2009-2013, according to the Center on Budget Policy and Priorities. While emergency federal aid and state reserve withdrawals helped close the gap, states could not avert large cuts in spending and raising taxes and fees. The Covid-19 pandemic has an added humanitarian dimension that elevates the need for timely state budget protection to a higher national security concern.

The case for states having more robust countercyclical budget policy...