How to Best Hand Out Money: How to Best Hand Out Money: Issues in the Design and Issues in the Design and

Structure of Intergovernmental Structure of Intergovernmental Aid FormulasAid FormulasThomas A. DownesThomas A. Downes

Department of EconomicsDepartment of Economics

Tufts UniversityTufts University

IntroductionIntroduction

Importance of aidImportance of aid Federal aid 7.3% of revenues in 1999-2000Federal aid 7.3% of revenues in 1999-2000 State aid 49.5%, largest source since 1978-79State aid 49.5%, largest source since 1978-79

Categorical v. general aid in the U.S. Categorical v. general aid in the U.S. contextcontext In 1999-2000, categorical aid provided 19% of In 1999-2000, categorical aid provided 19% of

revenuesrevenues Categorical share largest for districts with Categorical share largest for districts with

largest shares of “at-risk” students largest shares of “at-risk” students

Goals of this talkGoals of this talk

Issues addressed in talkIssues addressed in talk What are objectives of aid?What are objectives of aid? How do objectives translate into aid formulae How do objectives translate into aid formulae

and aid programs?and aid programs? What formula is implied by specific aid What formula is implied by specific aid

objective?objective? To what extent do actual formulas deviate from To what extent do actual formulas deviate from

ideal?ideal? What are implications of these deviations?What are implications of these deviations?

Objectives of AidObjectives of Aid Fiscal neutralityFiscal neutrality

Motivated by the existence of fiscal disparities – Motivated by the existence of fiscal disparities – differences among localities in fiscal capacity differences among localities in fiscal capacity and in cost of providing target level of public and in cost of providing target level of public servicesservices

Has both efficiency and equity rationalesHas both efficiency and equity rationales Equitable distribution of tax burdensEquitable distribution of tax burdens

Motivated by desire to eliminate inequitiesMotivated by desire to eliminate inequities Definition of horizontal and vertical inequitiesDefinition of horizontal and vertical inequities

Correct for inefficiencies in provisionCorrect for inefficiencies in provision Result of mismatch of providers and beneficiariesResult of mismatch of providers and beneficiaries Need to change incentives of providersNeed to change incentives of providers

ExamplesExamples State equalization aid to local school districtsState equalization aid to local school districts

Goal ‑ Reduce fiscal disparitiesGoal ‑ Reduce fiscal disparities Dominant types ‑ Foundation and Dominant types ‑ Foundation and

power‑equalizingpower‑equalizing Title I Education grantsTitle I Education grants

Goal – To provide districts serving significant Goal – To provide districts serving significant populations of economically disadvantaged populations of economically disadvantaged students with the resources to improve the students with the resources to improve the teaching and learning of these studentsteaching and learning of these students

Grants now go directly to most eligible school Grants now go directly to most eligible school districts, with grant amounts based loosely on the districts, with grant amounts based loosely on the number children in poverty and on state per pupil number children in poverty and on state per pupil expendituresexpenditures

Classes of GrantsClasses of Grants

Lump‑Sum grantsLump‑Sum grants Aid does not depend on actions of recipientAid does not depend on actions of recipient Block grants are an exampleBlock grants are an example Most categorical grants are lump sumMost categorical grants are lump sum

Matching grantsMatching grants Increased spending by recipient increases aidIncreased spending by recipient increases aid Open‑ended v. closed‑endedOpen‑ended v. closed‑ended

Designing formulae: Designing formulae: Common issuesCommon issues

Starting point: Closing need and effort gapStarting point: Closing need and effort gap Basic formula ‑ ABasic formula ‑ Ajj=F ‑ t=F ‑ t**VVjj (F is per‑capita (F is per‑capita

spending to supply target service level, tspending to supply target service level, t** is formula tax rate, Vis formula tax rate, Vjj is fiscal capacity) is fiscal capacity)

Common issuesCommon issues High capacity jurisdictions and recaptureHigh capacity jurisdictions and recapture Variation in services provided (equal access v. Variation in services provided (equal access v.

equal outcomes)equal outcomes) Multiple determinants of fiscal capacityMultiple determinants of fiscal capacity Cost adjustment ‑ ACost adjustment ‑ Ajj=C=CjjF ‑ tF ‑ t**VVjj (C (Cjj is cost index) is cost index)

Matching or Lump‑Sum?Matching or Lump‑Sum?

Objective: Fiscal neutrality ‑ Appropriate Objective: Fiscal neutrality ‑ Appropriate formula: Lump‑sumformula: Lump‑sum Conditions under which fiscal neutrality is Conditions under which fiscal neutrality is

achievedachieved Is result horizontally equitable?Is result horizontally equitable?

Objective: Equitable distribution of tax Objective: Equitable distribution of tax burdens ‑ Appropriate formula: Lump‑sumburdens ‑ Appropriate formula: Lump‑sum Operationalizing objective using average tax Operationalizing objective using average tax

effort to establish measure of fiscal capacityeffort to establish measure of fiscal capacity Will aid improve horizontal or vertical equity?Will aid improve horizontal or vertical equity?

Matching or Lump‑Sum?Matching or Lump‑Sum?

Objective: Correct for underprovision ‑ Objective: Correct for underprovision ‑ Appropriate formula: MatchingAppropriate formula: Matching Determinants of the matching rateDeterminants of the matching rate Killing two birds with one stone ‑ Can matching Killing two birds with one stone ‑ Can matching

aid also be used to mitigate locational aid also be used to mitigate locational nonneutralities?nonneutralities?

Can aid be used to reduce vertical Can aid be used to reduce vertical inequities?inequities?

Tension of objectivesTension of objectives

Implementation ProblemsImplementation Problems Accounting for cost/need variationAccounting for cost/need variation

Ad hoc nature of existing cost adjustmentsAd hoc nature of existing cost adjustments Problem 1: No accepted methodology for Problem 1: No accepted methodology for

estimating cost variationestimating cost variation Problem 2: Data issuesProblem 2: Data issues

Measuring fiscal capacityMeasuring fiscal capacity Choice of measure depends on objectiveChoice of measure depends on objective Preferred measure: Revenue that would be Preferred measure: Revenue that would be

obtained from applying formula tax rate to obtained from applying formula tax rate to available tax bases (Representative tax system)available tax bases (Representative tax system)

Implementation ProblemsImplementation Problems

RecaptureRecapture Tension ‑ Payments for services v. redistributionTension ‑ Payments for services v. redistribution Reality ‑ limited recaptureReality ‑ limited recapture

Local discretionLocal discretion Local discretion as an impediment to achieving Local discretion as an impediment to achieving

objectivesobjectives Should discretion be limited?Should discretion be limited? Can discretion really be limited? – The fungibility Can discretion really be limited? – The fungibility

problemproblem Potential solution ‑ composite aid formulaePotential solution ‑ composite aid formulae

Implementation ProblemsImplementation Problems Limiting budgetary liabilityLimiting budgetary liability

Tools for controlling liability (lump‑sum) ‑ target Tools for controlling liability (lump‑sum) ‑ target spending level, formula tax ratespending level, formula tax rate

Tools for controlling liability (matching) ‑ matching Tools for controlling liability (matching) ‑ matching rate, closed‑ended grantsrate, closed‑ended grants

Tensions between budgetary liability and objectivesTensions between budgetary liability and objectives Handling transitionsHandling transitions

Case for hold‑harmless provisions (stability, fairness)Case for hold‑harmless provisions (stability, fairness) Costs of hold‑harmless provisions (failure to achieve Costs of hold‑harmless provisions (failure to achieve

objectives, lock‑in of inappropriate aid distribution)objectives, lock‑in of inappropriate aid distribution) Reasons for failure to achieve objectivesReasons for failure to achieve objectives