How to Best Hand Out Money: Issues in the Design and Structure of Intergovernmental Aid Formulas

1. How to Best Hand Out Money: Issues in the Design and Structure of Intergovernmental Aid Formulas Thomas A. Downes Department of Economics Tufts University

2. Introduction • Importance of aid • Federal aid 7.3% of revenues in 1999-2000 • State aid 49.5%, largest source since 1978-79 • Categorical v. general aid in the U.S. context • In 1999-2000, categorical aid provided 19% of revenues • Categorical share largest for districts with largest shares of “at-risk” students

3. Goals of this talk • Issues addressed in talk • What are objectives of aid? • How do objectives translate into aid formulae and aid programs? • What formula is implied by specific aid objective? • To what extent do actual formulas deviate from ideal? • What are implications of these deviations?

4. Objectives of Aid • Fiscal neutrality • Motivated by the existence of fiscal disparities – differences among localities in fiscal capacity and in cost of providing target level of public services • Has both efficiency and equity rationales • Equitable distribution of tax burdens • Motivated by desire to eliminate inequities • Definition of horizontal and vertical inequities • Correct for inefficiencies in provision • Result of mismatch of providers and beneficiaries • Need to change incentives of providers

5. Examples • State equalization aid to local school districts • Goal ‑ Reduce fiscal disparities • Dominant types ‑ Foundation and power‑equalizing • Title I Education grants • Goal – To provide districts serving significant populations of economically disadvantaged students with the resources to improve the teaching and learning of these students • Grants now go directly to most eligible school districts, with grant amounts based loosely on the number children in poverty and on state per pupil expenditures

6. Classes of Grants • Lump‑Sum grants • Aid does not depend on actions of recipient • Block grants are an example • Most categorical grants are lump sum • Matching grants • Increased spending by recipient increases aid • Open‑ended v. closed‑ended

7. Designing formulae: Common issues • Starting point: Closing need and effort gap • Basic formula ‑ Aj=F ‑ t*Vj (F is per‑capita spending to supply target service level, t* is formula tax rate, Vj is fiscal capacity) • Common issues • High capacity jurisdictions and recapture • Variation in services provided (equal access v. equal outcomes) • Multiple determinants of fiscal capacity • Cost adjustment ‑ Aj=CjF ‑ t*Vj (Cj is cost index)

8. Matching or Lump‑Sum? • Objective: Fiscal neutrality ‑ Appropriate formula: Lump‑sum • Conditions under which fiscal neutrality is achieved • Is result horizontally equitable? • Objective: Equitable distribution of tax burdens ‑ Appropriate formula: Lump‑sum • Operationalizing objective using average tax effort to establish measure of fiscal capacity • Will aid improve horizontal or vertical equity?

9. Matching or Lump‑Sum? • Objective: Correct for underprovision ‑ Appropriate formula: Matching • Determinants of the matching rate • Killing two birds with one stone ‑ Can matching aid also be used to mitigate locational nonneutralities? • Can aid be used to reduce vertical inequities? • Tension of objectives

10. Implementation Problems • Accounting for cost/need variation • Ad hoc nature of existing cost adjustments • Problem 1: No accepted methodology for estimating cost variation • Problem 2: Data issues • Measuring fiscal capacity • Choice of measure depends on objective • Preferred measure: Revenue that would be obtained from applying formula tax rate to available tax bases (Representative tax system)

11. Implementation Problems • Recapture • Tension ‑ Payments for services v. redistribution • Reality ‑ limited recapture • Local discretion • Local discretion as an impediment to achieving objectives • Should discretion be limited? • Can discretion really be limited? – The fungibility problem • Potential solution ‑ composite aid formulae

12. Implementation Problems • Limiting budgetary liability • Tools for controlling liability (lump‑sum) ‑ target spending level, formula tax rate • Tools for controlling liability (matching) ‑ matching rate, closed‑ended grants • Tensions between budgetary liability and objectives • Handling transitions • Case for hold‑harmless provisions (stability, fairness) • Costs of hold‑harmless provisions (failure to achieve objectives, lock‑in of inappropriate aid distribution) • Reasons for failure to achieve objectives