To illustrate how substitution works, if states use federal funds to replace state spending on a dollar-for-dollar basis, then federally aided state services would remain at pre-grant levels—in which case the fiscal impact of the additional federal dollar on the intended program is zero. In practice, substitution effects are not this extreme; total state spending rises upon receiving federal grant funds—but by less than the full amount of the grant because states reduce their own spending for the area. In addition to this statistical analysis, our examination of substitution and targeting included (1) a comprehensive review of over 120 journal articles, reports, and econometric studies on substitution, targeting, and grant design factors related to both, (2) a synthesis of 50 econometric studies of federal grants, culminating in the development of point and range estimates of fiscal impact overall as well as for different time periods and grant designs, (3) a review of 23 GAO reports on options to achieve greater targeting in specific formula grant programs, and (4) an analysis of grants for design features associated with substitution and targeting. Grant Design Influences Fiscal Substitution

The economic literature we reviewed suggested that three types of grant design features affect the likelihood that states will use federal funds to supplement, rather than replace, their own spending. The first type of feature concerns the extent to which grant purposes are restricted. Therefore, the federal grants simply displaced, rather than supplemented, local spending. About half the 87 largest grants, representing 30 percent of the funds for those programs, did not require state matching. We examined whether existing federal grant allocations can be justified on the grounds that they provide budgetary relief to fiscally stressed states.We found that, controlling for differences in programmatic needs, grant allocations to states were not significantly higher for states with relatively fewer fiscal resources. Observations

Our analysis suggests that most grants are designed neither to reduce substitution nor to target funding to states with relatively greater programmatic needs and fewer fiscal resources. Others might argue that if the provision of fiscal relief is to be the primary goal of the federal grant system, then this relief should be allocated in a manner that allows for adequate oversight and control by the Congress. Notwithstanding the importance policymakers may place on providing states with fiscal relief, the question remains as to whether the federal government can afford this approach and still accomplish objectives of national importance in an era of increasingly scarce federal resources. Taking one path, the Congress could consider redesigning grants to reduce substitution and increase targeting. Also, if formula grants were redesigned to include a combination of targeting factors, a larger share of federal aid could be allocated to those states and communities with relatively greater programmatic needs and fewer fiscal resources. Accordingly, the Congress may decide that such programs no longer represent the best use of scarce federal resources. Such reductions could be used either to cut the deficit or invest in other federal programs that the Congress judges to be more cost-effective. However, because the evidence on whether states would replace reductions in federal grant funds is inconclusive, and because replacing federal funds would mean reductions to other state programs or increases in state taxes, the Congress would need to consider the costs and benefits of individual programs carefully in selecting which programs to reduce or eliminate. Scope and Methodology

This report examines the extent to which the federal grant system succeeds in two fiscal objectives often cited by public finance experts. First, do grants succeed in encouraging states to use federal dollars to supplement rather than replace their own spending on nationally important activities? 7-16. 3-6. 15-29. Chapter 13, “Grants-in-Aid System,” Economics of State and Local Government.
Why GAO Did This Study

Pursuant to a congressional request, GAO examined the federal grant-in-aid system from the perspective of fiscal impact, focusing on the extent to which the federal grant system succeeds in: (1) encouraging states to use federal dollars to supplement rather than replace their own spending on nationally important activities; and (2) targeting grant funding to states with relatively greater programmatic needs and fewer fiscal resources.

What GAO Found

GAO found that: (1) for the most part, the federal grant system does not encourage states to use federal dollars to supplement rather than replace their own spending on nationally important activities; (2) grants are unlikely to supplement completely a state's own spending; (3) GAO's review and analysis of economists' most recent estimates of substitution suggests that every additional federal grant dollar results in less than a dollar of total additional spending on the aided activity; (4) with the responsibilities of states increasing in the federal system, some observers may view this substitution as a legitimate means of providing states fiscal relief and budgetary flexibility; (5) the Congress has various criteria available to address how such relief should be allocated among the states; (6) GAO's analysis of the extent to which the fiscal relief provided by grants is allocated to states with relatively greater programmatic needs and fewer fiscal resources indicated that federal aid is not targeted to offset these fiscal imbalances; (7) GAO's analysis also suggested that the practice of placing constraints in grant formulas to assure all states a minimum amount of funding has contributed to this lack of targeting; (8) these fiscal substitution and targeting results reflect the way in which most of the 633 federal grants GAO examined are designed; (9) a majority of the 87 largest grant programs did not include features to encourage states to use federal funds to supplement rather than replace their own spending; (10) a number of strategies for increasing the fiscal impact of grants are available to the Congress, depending on the value the Congress places on this goal relative to other grant goals and objectives; (11) grant redesign is one strategy for reducing substitution or targeting fiscal relief to states with greater fiscal stress; (12) in redesigning grants, the Congress would need to consider how best to balance grant restrictions needed to reduce substitution against possible decreases in state budgetary flexibility and discretion; (13) if states do not share the federal government's programmatic objectives, high levels of substitution may occur even after design changes; (14) alternatively, the Congress could decide that particular programs no longer represent the best use of scarce federal resources, which would free up budgetary resources that could be used to reduce the deficit or invest in more promising programs; (15) like the first strategy, grant spending cuts also involve tradeoffs; and (16) depending on the size and area of the reductions, states would incur varying degrees of budgetary stress and might face the prospect of increased state taxes, cuts in state programs, or some combination of both.