BACKGROUND PAPER

As Required by Public Law 94-369

Countercyclical Uses

of Federal Grant Programs

November 1978

Congress of the United States

Congressional Budget Office

Washington, D.C.
CONGRESSIONAL BUDGET OFFICE Alice M. RMIn

U.S. CONGRESS Director

WASHINGTON, D.C. 20515

November 27, 1978

The President of the Senate

The Speaker of the House of Representatives

Dear Mr. President and Mr. Speaker:

Section 215(b) of the Public Works Employment Act of 1976

requires the Congressional Budget Office to study the means by

which the federal government can stabilize the national economy

by the countercyclical use of federal grants to state and local

governments. This paper, Countercyclical Uses of Federal Grants,

is CBO's response to that mandate. As required by the Act, we

enclose the comments of the Comptroller General of the United

States.

The study examines triggering devices that activate federal

aid to state and local governments. It focuses on means of

targeting aid toward geographical and population sectors most

in need. It also discusses the problems of federal constraints

and fiscal substitution in recipient jurisdictions in the

context of achieving national economic objectives, as well as

options for using existing federal grants in a countercyclical

fashion.

We hope that Members of Congress find this report useful.

We would be pleased to respond to any questions.

Respectfully submitted,

G

Alice M. Rivlin

Director
COMPTROLLER GENERAL OF THE UNITED STATES

WASHINGTON, D.C. 20548

B-146285 November 9, 1978

The Honorable Alice M. Rivlin

Director, Congressional Budget

Office

Dear

We have received your draft of Countercyclical Uses of Federal

Grant Programs, which was prepared in response to Section 215(b) of the

Public Works Employment Act of 1976. We have reviewed this draft with

interest and find it provides a useful overview of the discussion that

has taken place over the course of the last two years concerning the

appropriateness and effectiveness of Federal antirecession assistance

to State and local governments.

We are happy to note that you found our reports on "Antirecession

Assistance—An Evaluation" (PAD-78-20, November 29, 1977) and on the

impacts of antirecession assistance on State, county, and city governments (GGD-77-76; GGD-77-60; GGD-77-69; and GGD-77-70) useful in the

preparation of your report. Your analysis and findings concur with the

major points that we have developed in our studies of the antirecession

assistance programs.

We believe that your differentiation between the stabilization of

the national economy and the "fiscal stabilization" of State and local

budgets is a useful distinction and should help clarify the different

objectives of antirecession assistance. Two additional points made in

the draft are worthy of special note because they represent perspectives

that have not received sufficient notice in previous analytical work:

(1) social service and transfer programs are difficult to turn off once

they are initiated as antirecession programs, (2) general revenue sharing

combined with antirecession assistance may be effective in offsetting

fiscal destabilization in State and local budgets.

The analysis contained in your report should provide the Congress

with useful information and again demonstrates the difficulty of designing

one program to meet multiple objectives.

Comptroller General

of the United States

COUNTERCYCLICAL USES OF FEDERAL GRANT PROGRAMS

The Congress of the United States

Congressional Budget Office

For sale by the Superintendent of Documents, U.S. Government Printing Office Washington, D.C. 20402

Stock No. 052-070-04744-5
NOTE

All dates refer to calendar years

unless otherwise noted.
PREFACE

This study was undertaken by the Congressional Budget

Office in response to a directive contained in paragraph 215(b)

of the Public Works Employment Act of 1976 (P.L. 94-369). The

study examines the potential uses of federal grants to state

and local governments to affect employment, output, income,

prices, and state and local budgets.

The report was written by Sophie Korczyk of CBO's Human

Resources and Community Development Division under the supervision of Robert D. Reischauer and David S. Mundel. Stephen

Barro, a consultant to CBO, wrote the manuscript on which this

report is based. The author wishes to thank Peggy Cuciti,

Stanley Czerwinski, Paul Ginsburg, Roger Vaughan, and Larry

Wilson for valuable assistance. Johanna Zacharias edited the

manuscript. Jill Bury patiently and expertly typed the many

drafts of the paper.

In accordance with CBO's mandate to provide objective

and impartial analysis, this paper contains no recommendations.

Alice M. Rivlin

Director

November 1978

ill

CONTENTS

Page

PREFACE Ill

SUMMARY ix

CHAPTER I. INTRODUCTION AND PLAN OF THE PAPER 1

CHAPTER II. POLICY GOALS 3

Stabilization of the General Economy 4

Fiscal Stabilization 4

Targeting 6

Increasing Productive Capacity 7

CHAPTER III. THE DESIGN OF GRANT PROGRAMS: TRIGGERING

AND TARGETING 9

Factors Determining the Effectiveness of Grants . . 9

Triggering and Timing 10

Targeting 14

CHAPTER IV. NATIONAL AND LOCAL CYCLICAL INDICATORS .... 19

Indicators of Employment, Income, and Output .... 19

Indicators of State and Local Fiscal Distress ... 27

Indicators of Inflation and Excess Aggregate

Demand 28

CHAPTER V. SELECTION AND REGULATION OF GRANT RECIPIENTS . 31

Federal Control Over Grant Financed Spending .... 31

The Selection of Recipients for Countercyclical

Grants 32

Methods for Limiting Fiscal Substitution 38

Methods for Influencing the Timing of

Expenditures 41

Methods of Controlling the Distribution of

Grant Benefits 42

35-946 O - 78 - 2
CONTENTS (Continued)

CHAPTER VI. POTENTIAL COUNTERCYCLICAL USES OF

GRANT PROGRAMS 45

The Countercyclical Use of Unrestricted Grants

GRS and ARFA 48

The Countercyclical Use of Capital Construction

Grants 52

The Countercyclical Use of Social Services Grants . 54

The Countercyclical Use of Grants for Transfer

Payment Programs 56

Summary and Conclusions 60

vi
TABLES

Page

1. Aid Triggers Derived from Different Computations

of Unemployment Caused by Recession, By State .... 22

2. State and Local Direct, General Expenditures, by

Function: Fiscal Year 1975-1976 33

3. State and Local Direct Expenditure, by Character

and Object: Fiscal Year 1975-1976 34

4. State and Local Revenues by Major Source:

Fiscal Year 1975-1976 35

5. Major Federal Grant Programs, Estimates of Budget

Authority and Outlays, Fiscal Years 1978 and 1979 . . 46

FIGURE

1. Comparison of Price Indexes 29

vii

SUMMARY

Federal grants to states and localities have historically

been used to encourage the recipients to pursue activities that

improve the quality of living in those places. Among the aims of

such grants have been advancing educational equality, improving

the natural environment, and reducing poverty.

In recent years, the federal government has also sought

to further macroeconomic goals—such as increasing aggregate

income, employment, and output—through aid to state and local

governments. For example, the recent recession prompted the

enactment of three programs that provided grants designed to

help stabilize macroeconomic conditions: Antirecession Fiscal

Assistance (ARFA), Local Public Works (LPW), and Comprehensive

Employment and Training Act/Public Service Employment (CETA/PSE).

Besides affecting macroeconomic conditions, these programs were

also intended to stabilize the budgetary position of state and

local governments and to ameliorate the problems of individuals,

places, and economic sectors that were particularly hard hit by

recession.

The simultaneous pursuit of economic stabilization, stabilization of state and local budgets to avoid service cutbacks or

tax increases, and increased financing of certain activities that

further federal objectives may entail conflicting policies.

Economic stabilization requires that grants increase during a

recession in order to stimulate demand, and that, during periods

of inflationary pressure, they decrease as aggregate demand

approaches or exceeds the limits of available resources.

Fiscal stabilization may require a different time path of

grant flows. During a recession, grants should increase to

compensate for cyclical fluctuations in revenues and expenditures. But fiscal stabilization during inflation, regardless of

whether the inflation coincides with excess aggregate demand, may

require an increase in grants to compensate for increased costs.

Service provision demands a steady flow of resources in order

that careful program development and implementation can occur and

that vital activities not be disrupted.

ix
These conflicting demands for funding expansion and contraction complicate the use of grants for economic and fiscal

stabilization*

TRIGGERING. TARGETING. AND MEETING

FEDERAL OBJECTIVES

The effectiveness of state and local grants in achieving

economic and fiscal stabilization depends upon three factors:

o When the aid is distributed or cut back and by how much

(triggering and timing);

o Which areas or governments receive aid (targeting);

and

o How the federal government assures that the grants

will be used for the purposes designated (constraints).

Triggering

Choosing a triggering mechanism that turns aid on and off

and that adjusts funding to changes in cyclical indicators

involves several factors. First is the choice between discretionary and automatic funding mechanisms. On the one hand, the

decision can be made each year by the Congress and the President

based on the economic circumstances and competing priorities. In

all three of the recent stabilization grant programs, yearly

funding decisions by the Congress determine whether aid is

available and if so how much is distributed; only in ARFA is the

exact amount of aid authorized directly linked to unemployment.

Because of the time lags built into the authorization, appropriation, and implementation of such discretionary grant triggers,

aid is likely to be mistimed with respect to need for countercyclical assistance. On the other hand, the authorization

and appropriation can be made available for several years provided that certain economic conditions signifying the need for

such aid are met. The use of automatic on/off triggers and

scaling the amount of aid to the rate and duration of decline or

recovery, not just the level of economic activity, could increase

the sensitivity of the programs to state and local cyclical

needs.
The second choice raised by the triggering issue is what

mechanism to use to get an indication of need for grant support

and of the appropriate level of support. The triggering indicator most often used is the unemployment rate. From the point

of view of availability and reliability, the unemployment rate

has many advantages. Other macroeconomic variables—wages and

salaries, employment levels, and output—represent important

dimensions of economic cycles that are not captured by unemployment rates, however. The choice among triggering indicators

rests on availability and timeliness of state and local data. On

these points, the unemployment rate dominates.

The final choice with respect to the triggering mechanism

concerns the form of the formula. The ARFA formula uses the

national unemployment rate in excess of some threshold level to

determine the total amount of aid to be distributed. Were other

economic variables—such as wages and salaries, employment

levels, or output—to be used, the program could be triggered by

a decline in the absolute value of the indicator, a decline

relative to its previous peak value, or a decline relative to its

long-term growth trend.

Targeting

Effective targeting can advance the stabilization goals

by reducing inflationary pressures. If aid is directed primarily

at areas with unemployed resources, this could redistribute

demand so as to optimize resource utilization. The identification of localities in need is difficult, however, for while

the measure of need attempts to identify cyclical problems of

localities, in some cases it may measure long-term decline.

The two main criteria upon which cyclical targeting depends

are the sensitivity of a jurisdiction's revenues and expenditures to inflation and recession, and the extent to which

cyclical problems affect the area. In general, state revenues

and expenditures tend to be more sensitive to recession than

those of localities. Inflation increases state revenues more

than it does local revenues, but it affects expenditures of both

state and local governments. The sensitivity to cyclical disturbance depends upon the particular types of taxes upon which

each jurisdiction relies, the services it is responsible for

providing, and the responsiveness of state aid -£o local budgetary problems caused by economic cycles. Distinctions among local

jurisdictions are difficult to make.

xi
The measure most often used to indicate an area's cyclical

need is its local unemployment rate. No state and local economic

or fiscal indicators are so reliable or readily available,

even though others may be more representative of the disruption

to the local economy, state and local government budgets, and

public services caused by recession or inflation.

Local cyclical need is easily confused with longer-term

or "structural" problems. Current countercyclical programs

distribute aid to jurisdictions in large part based on their

unemployment rates. But this does not differentiate regions

with high but long-term levels of unemployment from those with

cyclical problems that can be relieved by temporary aid. Using

the unemployment rate as a criterion for distributing aid may

simply serve to give temporary relief to areas with structural

unemployment problems. This may cause problems when aid is

discontinued due to national recovery while local need persists.

In addition, the problems faced by such areas might be better

addressed by programs more explicitly aimed at the causes of

structural problems—for example, at an absence of private sector

activity, or at a lack of a skilled labor force.

Constraints on Grantees

For grant programs to meet economic, not fiscal, stabilization goals, the grants must include provisions to assure that the

funds are used for the specific purpose of stimulating aggregate

demand. Fiscal substitution—the use of federal funds to replace

local money that would have otherwise been spent—weakens the

economic stabilization effects of grants. Such substitution

can be limited by earmarking the grants for certain uses, by

requiring additivity (that is, making sure that the grant funds

add to other monies being spent), and requiring matching funds

from local sources. Another constraining provision can be

that aid be focused on disadvantaged groups of people as well

as disadvantaged localities. Such constraints can cause delays

in spending the grants, however. These delays can be averted by

the use of fiscal incentives to reward prompt action and by

streamlining program requirements to cut down on bureaucratic

procedures.

xii
ADAPTING GRANT PROGRAMS FOR

COUNTERCYCLICAL USE

The objectives of countercyclical grants to state and local

governments can be pursued either by initiating temporary programs or by adapting existing federal grants. To date, the

former strategy has been followed, but interest in the latter

approach has been expressed. Four types of grants are large

enough and suitably constructed so that they can be effectively

used for countercyclical purposes. In general, such grants can

be adapted for countercyclical use by varying either the funding

level or the share of program costs paid by the governments.

Unrestricted grants of the form of General Revenue Sharing

(GRS) and ARFA are more effective for fiscal than for economic

stabilization, because grantees are not limited in their use of

the funds.

Capital construction grants can be adapted both for fiscal

and economic stabilization. Fiscal stabilization can be pursued

by varying the state and local matching rate in programs with

such requirements. Economic stabilization can be pursued by

varying the numbers or scale of grant-aided projects and by

accelerating or delaying programs. The Community Development

Block Grant program, while it supports capital construction,

offers grantees enough flexibility that it resembles GRS in terms

of its countercyclical potential and effects.

Social services grants are difficult to use for countercyclical purposes because they serve disadvantaged segments

of the population, and thus variations in the level of these

services would have an undesirable effect on the well being of

these groups. Several social services programs are, however,

potential candidates for -countercyclical use because variations

in funding would not have this disruptive effect. The community

services program supports small-scale, short-duration projects

that could be pursued with temporary funding. Federal contributions to the social services grant program could be varied

countercyclically.

Transfer payment programs have the same limitations as

countercyclical tools as do social services grant programs. The

required local matching rate for these programs could be varied

for fiscal stabilization purposes, however.

xiii

35-946 O - 78 - 3

CHAPTER I. INTRODUCTION AND PLAN OF THE PAPER

In response to the recent recession, the Congress passed a

number of special grant programs to aid state and local governments. These "countercyclical" programs are intended to offset

the effects of local economic slowdowns and fiscal disruption, or

to dampen overheated economic activity.

Because little was known about such an approach to combating

recession or inflation, the Congress directed that studies be

undertaken of the design, effects, and implications of such

grants. One such directive, contained in Section 215(b) of the

Public Works Employment Act of 1976, called on the Congressional

Budget Office (CBO), the Advisory Commission on Intergovernmental

Relations (ACIR), and the General Accounting Office (GAO) to

. . . conduct a study to determine the most effective

means by which the Federal Government can stabilize the

national economy during periods of rapid economic growth and

high inflation through programs directed toward State and

local governments. Such study shall include a comparison

of the effectiveness of alternative factors for triggering

and measuring the extent of the fiscal coordination problem addressed by this program, and the effect of the recession on State and local expenditures .... _!_/

This report was undertaken in response to this mandate. J7

\J Public Law 94-369, July 22, 1976.

2_/ This report extends CBO's analysis of antirecessionary programs and considers explicitly the use of these programs as

counterinflationary tools. Earlier CBO reports presented

both general and empirical analyses of the employment and GNP

effects of antirecessionary programs. See Temporary Measures

to Stimulate Employment: An Evaluation of Some Alternatives

(September 2, 1975) and Short-Run Measures to Stimulate the

Economy^ (March 1977). A subsequent paper explored the impacts of phasing down these programs in the current recovery.

See Phasing Down the Antirecession Programs (June 30, 1978).

1
A division of labor was agreed to under which the ACIR concentrated on the fiscal coordination problem and the effects of

recession on state and local governments. J3/ CBO has focused on

"targeting" and "triggering"—that is, determining the amount,

timing, and distribution of aid. CBO has also evaluated other

aspects of alternative aid mechanisms, including the adaptation

of existing state and local grant programs for countercyclical

use. The GAO report identifies alternatives available to Congress when it considers renewing the antirecession programs, kj

This report deals with the following questions:

o What are the goals of stabilization grants and how

might they reinforce and conflict with each other?

(Chapter II.)

o To what extent do triggering mechanisms that increase

or decrease aid in response to economic conditions

and targeting mechanisms that concentrate aid on specific

sectors, groups, or areas enhance the effectiveness

of these grants? (Chapter III.)

o What measures of economic activity are most suitable

for triggering and targeting purposes? (Chapter IV.)

o How can such grants be designed and administered to

influence appropriately the fiscal responses of recipient

jurisdictions? (Chapter V.)

o How can existing countercyclical grants be made more

effective and how can grants not specifically designed

for countercyclical purposes be converted to play a

role in economic stabilization policy? (Chapter VI.)

The discussion gives special consideration to the potential uses

of countercyclical grants to reduce inflationary pressure.

3/ Advisory Commission on Intergovernmental Relations, Federal

Stabilization Policy; The Role of State and Local Government. Washington, D.C. (July 20, 1978).

_4/ U.S. General Accounting Office, Report to the Congress;

Impact of Antirecession Assistance on 52 Governments (May 1,

1978).
CHAPTER II. POLICY GOALS

During 1975 and 1976, three countercyclical grant programs

were enacted into law:

o The Antirecession Fiscal Assistance (ARFA) program (known

as "countercyclical revenue sharing"), which distributes

general-purpose funds to states and localities;

o The Local Public Works (LPW) program, which funds construction projects undertaken by state or local governments ; and

o The Public Service Employment (PSE) component of the

Comprehensive Employment and Training Act (CETA), which

pays the salaries of certain workers hired by state and

local governments or nonprofit organizations.

As of the end of fiscal year 1978, $19.4 billion had been allocated under the three programs for expenditure in fiscal years

beginning with fiscal year 1976.

Although grants for public works, public employment projects, and increases in transfer payments, have been used before

as antirecessionary devices, the new grants have features

that set them apart from their predecessors. All three of the

new programs have been implemented and operated at the state and

local levels, but financing for the programs has been federal.

The programs distribute funds among states and localities using

formulas that incorporate unemployment measures. In the case of

ARFA, a "triggering" mechanism increases and decreases the

overall flow of aid at different points in the cycle. The

distribution formulas and triggers can be considered steps toward

establishing the grants as automatic—rather than discretionary—

economic stabilizing tools.

Stabilization grants have at least four related goals:

o Maintaining acceptable aggregate levels of employment,

output, income, and prices;
Stabilizing state and local budgets by reducing cyclical

service cutbacks and tax increases;

Directing aid to the geographic areas, economic sectors,

and population groups most affected by recession or

inflation; and

Increasing productive capacity by encouraging investment

in labor force skills and public and private sector

capital stock.

STABILIZATION OF THE GENERAL ECONOMY

As is true of all stabilization policy tools, stabilizing

the economy with grants means achieving desired levels of employment, income, output, and prices. Different stabilization grants

will have different effects on these variables, at least in terms

of immediate impact. A public service employment program may

generate large numbers of low-paid, low-productivity jobs. A

construction program or other capital-intensive project may

generate more output but fewer and more highly-paid jobs. A cash

or in-kind transfer program, in contrast, will directly produce

income but no output or employment.

The impact of stabilization programs on prices will depend

on the level of resource utilization and composition of the

resource pool in the area or sector toward which the program is

targeted. If a program requires highly specialized labor or

other scarce resources, then the overall rate of inflation will

be affected more adversely than if the program required unspecialized labor and abundant resources. I/

FISCAL STABILIZATION

Fiscal stabilization means the narrowing of cyclical fluctuations in the expenditures and revenues of state and local

\_l Resource scarcity is only one reason grants could contribute

to inflation. Inflationary pressures could also result if

funds are used to supplement salaries of existing government

employees.
governments. Governments faced with recession-caused slides in

revenues, or with price rises caused by inflation, may be forced

to cut back services or raise taxes. Service cutbacks not only

impair the achievement of the objective of the particular activity, they also cause declines in income, employment, or both.

On the revenue side, increases in taxes in response to recession

or inflation may avoid service cutbacks, but only at the expense

of further reducing aggregate demand and/or adding to the cost of

living. Fiscal stabilization is thus important for two reasons:

for its effects on service provision, and as a means of achieving

economic stability.

These effects of federal grants on the expenditures and

revenues of state and local governments cannot easily be achieved

with other fiscal tools. Federal tax cuts cannot be targeted

geographically, nor do they have a direct impact on state and

local revenues and expenditures. To the extent that tax cuts

stimulate economic activity, they can contribute to state and

local budget stabilization, but with delays that limit their

usefulness for fiscal stabilization policy. Countercyclical use

of direct spending activities leads to delays in spending which

reduce countercyclical effectiveness. And again, federal spending is not likely to have a direct impact on state and local

finances.

The Relationship Between Economic and

Fiscal Stabilization

Macroeconomic conditions—the level of income, output,

employment and prices—determine whether economic and fiscal

stabilization require the same policy actions:

o During a recession, both goals require increased grant

flows so as to generate output and employment, to

offset revenue losses caused by the recession, and to

support the necessary increased social services and

unemployment compensation.

o During inflation accompanied by recession, fiscal stabilization requires increased grants to offset recessioncaused hardships and the budgetary problems which occur

if inflation raises the costs of state government faster

than it raises revenues. Since price changes in response

to increases in demand occur very slowly, it may be
possible to pursue economic stabilization through the

same stimulatory grant policies. Such policies should

be carefully targeted on areas and sectors with excess

supplies of labor and other resources.

If inflation occurs with full employment and rapid

growth, economic stabilization suggests that grants be

cut. Prices will probably react very slowly to such

cuts. Fiscal stabilization requires increased grants to

offset the adverse fiscal effects of rising costs if

revenues do not increase at the same rate.

TARGETING

Directing program impacts toward certain economic sectors,

geographic areas, and population groups is important in order

to affect equity or fairness of income distribution and also

to enhance the effectiveness of overall stabilization policy.

Impacts on Economic Sectors. The rationale for considering

sectoral impacts is the broad variations among industries in

cyclical sensitivity. Sensitive sectors include construction,

durable consumer goods, and industrial machinery and equipment.

Other things being equal, directing antirecessionary stimuli

toward the more sensitive sectors would be desirable for two

reasons. First, generating increased output, income, and

employment in sectors with substantial unused capacity should

be easier. Second, if there were sharp increases in the demand

for the output of sectors not significantly harmed by the recession, bottlenecks and shortages could develop, leading to

inflation. By the same reasoning, the achievement of antiinflationary goals would be facilitated by focusing so-called

"contractionary" policies on sectors in which rates of output

are straining capacity or, especially, on sectors where capacity

constraints are generating shortages and price increases.

Impacts on Population Groups. Disadvantaged groups are

likely to bear disproportionate shares of the burdens of economic

cycles. As marginal workers, they are more likely to be laid

off during recessions and to be the last hired during recoveries.

Again, along with the distributional goal, macroeconomic goals

can also be served when grants are earmarked for, say, jobs for

the disadvantaged. This is because a dollar' spent on an employment project will have a greater first-round impact on employment

than will a dollar spent on a capital-intensive project.
Geographic Targeting. Targeting aid to jurisdictions

according to fiscal or economic need has been deemed desirable

both on grounds of equity and as a means of enhancing the

effectiveness of stabilization efforts. But these two purposes

can lead to conflicting criteria for assessing the geographical

distribution of countercyclical aid.

The equity argument for targeting is based on the federal

interest in the economic activity, tax burden, and available

services in particular regions and localities. This suggests

that the areas hardest hit by cyclical problems should be favored.

In contrast, the effectiveness of stabilization policies may

be improved if funds are channeled to those areas likely to

generate the greatest increase in economic activity or to display

the most fiscal improvement, since there ar large variations

among regions and localities in the severity and timing of

cylical problems. 2.1 Targeted areas may be worse off or simply

may have a greater potential for quick improvement.

INCREASING PRODUCTIVE CAPACITY

Several aspects of economic efficiency need to be considered

in evaluating alternative countercyclical programs.

Economic Value. Economic value of activities undertaken

or foregone in a countercyclical program is difficult to determine for two reasons. First, there is no market criterion for

assessing the value of public sector activities. Second, lower

costs should be attributed to the resources consumed by antirecessionary programs if they would be unemployed or underemployed in the absence of an active stabilization policy because

these resources would not then be generating income or output.

Effect on Long-Run Economic Efficiency. Countercyclical

programs may affect the structure of the economy in the following

ways:

2_l Interregional and inter-area variations in cyclical patterns

are documented in Georges Vernez, et al., Regional Cycles

and Employment Effects of Public Works Investments, The

Rand Corporation, R-2052-EDA (January 1977), Chapter II.

35-946 O - 78 - 4
Programs aimed at stimulating economic activity in

the short run may affect the level, composition, and

geographic distribution of the public and private capital

stocks for years to come.

Programs aimed at generating employment during recessions

may help unemployed workers, youths, and others to

obtain skills and experience, thereby improving such

people's own future employment prospects and adding to

the overall productive capacity of the labor force.

Programs that tend to sustain activity in declining

industries and locations are likely to hinder long-run

economic performance, while those that focus on sectors

and areas with long-run growth potential are likely

to improve long-run resource allocation.
CHAPTER III. THE DESIGN OF GRANT PROGRAMS:

TRIGGERING AND TARGETING

FACTORS DETERMINING THE EFFECTIVENESS OF GRANTS

Whether grants to state and local governments are effective

as stabilization tools depends on four factors:

o What circumstances prompt the disbursement of funds,

and how much money is distributed (the triggering

mechanism);

o Which groups, sectors, and localities receive the aid

(the targeting mechanism);

o The adequacy of measures of economic activity chosen to

trigger and target aid; and

o Whether the use of the funds furthers stabilization

goals.

This chapter presents alternative mechanisms for triggering

and targeting.

The triggering mechanism determines whether the aid will

reinforce or offset the macroeconomic disturbance. If aid

is increased during a recovery, it may exacerbate inflation as it

furthers the recovery. If it is decreased during a decline, it

may further reduce income, employment, and output. To deal with

these possibilities, the timing and duration of aid and the

duration of the economic effects of aid need to be responsive to

changes in economic circumstances.

The targeting mechanism increases the program's effectiveness in stabilizing both the economy and the budgets of state and

local governments. Increases in employment and output can be

achieved—and with little pressure on prices—by targeting

stimulative policies to areas, sectors, and population groups

with substantial excess productive capacity. Contractionary

policies can be directed to those segments of the economy experiencing actual or threatened resource shortages. State and local
The aggregate level of aid under all three current antirecessionary programs (ARFA, CETA/PSE, and LPW) is directly or

indirectly determined by the strength of the national economy.

In ARFA, an explicit trigger based on the unemployment rate is

used. In LPW and CETA/PSE, the total amounts are set by the

Congress. In all three programs, targeting to localities is

based on subnational unemployment rates and other local characteristics. Each area's aid depends on the severity of its

problems relative to those of other areas, since the total amount

of aid to be shared at any one time is fixed.

TRIGGERING AND TIMING

The following factors are essential in the triggering and

timing of countercyclical aid:

o A threshold level of the indicator—for example, unemployment—which determines the minimum amount of economic

contraction required to trigger aid and the minimum

amount of recovery needed to turn it off;

o A sustained effect or duration indicator, which sets the

time the contraction must last before the aid is initiated; and

o A calculation method to determine the amount by which

aid changes in response to the threshold indicator,

improves or worsens.

Additional considerations include:

A choice about whether the stabilization component should

be added on to a regular grant or whether the stabilization grant should be activated only when cyclical conditions warrant; and

A choice about whether countercyclical grants should be

funded automatically when the threshold is reached or

whether funding should be dependent on Congressional

discretion.

10
Threshold Level

The threshold for a recession may be defined as a simple

absolute worsening in the indicator relative to current levels, a

level worse than its potential value, or a level worse than the

long-run growth trend of the indicator. Thresholds that have

been considered include unemployment rates in excess of enduring

so-called "structural" levels, declines in absolute employment,

and declines in income, wages, and salaries. These alternatives

are discussed further in Chapter IV.

In an economy with a growing population and labor force and

with expectations of rising living standards, declines of key

indicators such as income relative to long-run growth trends are

more reliable measures of economic distress than are absolute

declines. A threshold indicator defined as a decline below trend

is more sensitive to change in a dynamic economy. Furthermore,

such an indicator would trigger aid more easily than would one

responsive only to absolute declines.

Another possibility is to use as a trigger a decline below

potential value of the indicator. The problem with this choice

is the difficulty of computing the potential value of an indicator, discussed further in Chapter IV.

Decreasing aid during a recovery is complicated by disagreement over how recovery, as well as recession, should be

defined. Recovery may be a return to the previous peak level of

economic activity, or to the current level of potential GNP—

which will be higher than the former peak because of increases in

the labor force and the capital stock.

Sustained Effect

One example of an indicator of sustained effect or duration

is the requirement that unemployment must exceed the threshold level for three consecutive months for aid to be activated.

A similar sustained-effect standard could be established for

triggering anti-inflationary cuts in aid. Such an indicator

could help distinguish transitory or isolated economic adjustments natural to a growing economy from disturbances that affect

a number of sectors and cause a prolonged decline in several

measures of economic activity.

11
The higher the threshold and the longer the contraction is

sustained before aid commences, the less likelihood of the

program responding to a false indication of a recession. But

an accompanying risk is that grants would be delayed beyond the

time when such stimulus would be useful.

Methods for Calculating Aid

The rate at which aid responds to changes in the indicator

depends on the calculation method chosen. The simplest triggering mechanism is an on/off switch that causes aid to flow

at a predetermined, constant rate once circumstances in the

economy have fallen below a certain mark in the indicator.

With such a trigger, the level of funding is not sensitive to

variations in the severity of the cycle as measured by further

changes in the indicator.

One way of linking the amount of aid to the severity of

the cycle is to make the aid increase in proportion to the

amount by which the cyclical indicator exceeds its threshold.

The ARFA triggering formula is a combination of the on/off switch

and the proportional formula. The total volume of aid consists

of the fixed amount of $125 million, which is available when the

unemployment rate is in excess of 6 percent, and the variable

amount, which is proportional to the amount of unemployment over

6 percent.

An alternative, suggested by GAO (1977), _!_/ is a formula

that permits aid to increase more than in proportion to the

severity of the cycle. Such a formula could be adapted to

respond to the speed at which the economy is declining or

to the duration of the recession. This alternative could also

offset the effect of the delays in data availability and

program implementation—which make aid smaller than needed during

a recession and greater than needed during a recovery—by adding

aid at a rate rapid enough to compensate for the delays.

Aid calculation methods can be modified to take account

of inflation in one of two ways. Indexing grants for changes in

\J U.S. General Accounting Office, Antirecession Assistance—

an Evaluation (November 29, 1977), p. 43.

12
the price level means that aid increases at the same rate as

inflation to maintain a constant real level of aid. This only

partially deals with the fiscal disruption due to inflation.

If expenditures increase at a more rapid rate than do revenues,

then aid may need to be increased more rapidly than inflation

to avoid a growing deficit. These methods do not attempt to

identify the portion of inflation that may be caused by the

behavior of the state and local sector.

Indexing is necessary if the legislation determining funding

is to remain unchanged for several years. If aid is not adjusted

for price changes, the program becomes an increasingly weak

fiscal instrument. An alternative to building a price index into

the triggering formula is to calculate aid in relative terms—

for example, to specify that the amount of antirecessionary aid

should be a fixed percentage of the amount by which actual GNP

falls short of potential GNP. Either method will maintain the

real purchasing power of grant recipients, which in turn aids

fiscal stabilization.

Changing the real level of aid in response to inflation

could be accomplished using several methods of calculation.

Aid can either be increased to relieve fiscal pressures on state

and local governments or decreased to avert or relieve inflationary pressures due to resource shortages. One approach

is to treat the degree of economic slack as only a threshold

condition and to make the size of the aid change an increasing

function of the rate of inflation. The flow of aid would begin

once unemployment reached a certain level, but the amount of aid

would be proportional to the inflation rate. A more general

solution would be to develop a formula that dispenses aid in

proportion to both the rate of inflation and the degree of

economic slack.

Add-On or Separate Stabilization Grant?

Distributing stabilization grants as an add-on to an

ongoing service-provision grant increases the speed with which

aid can be transmitted. Add-ons reduce administrative costs

since little new bureacracy is required; localities have experience in spending the federal grant funds. But countercyclical variations in the provision of some services can be

detrimental to the accomplishment of program goals. Interference

13
of stabilization with program goals and possible solutions are

discussed in Chapter VI.

Automatic Stabilizer or Discretionary Grant?

All three countercyclical programs require Congressional

action to start the flow of aid. Thus, in addition to the delays

for obtaining information and implementing the program, a possible legislative delay is built into the programs.

Countercyclical grants could possibly operate in a fully

automatic manner, as does the personal income tax which stabilizes because of its progressive rates. Transfer programs also

are automatic stabilizers because they act automatically to

cushion declines in disposable income. An automatic trigger

would improve the timing of countercyclical grants and could

allow their use as anti-inflationary as well as antirecessionary

tools. At the same time, however, it would increase the nondiscretionary component of the federal budget and reduce the

flexibility of the Congress in responding to changing social

priorities. Creating a fully automatic stabilization grant

program would imply a judgment that the goals of these grants are

important enough and the grants are effective enough to warrant

the sacrifice in flexibility.

TARGETING

Two general issues concerning the design of the targeting

mechanism emerge:

o Which jurisdictions are to be eligible and how should

need be defined?

o How much aid will jurisdictions receive? Should aid

be tied to local measures of need? Should aid be distributed according to a regular grant-distribution

formula or according to another distribution formula?

This section discusses the options for formula design.

14
Eligibility

A local cyclical indicator can be used in several forms

to represent local need and determine eligibility.

Deviations from Previous National Cycle Peak Value. The

current value of the indicator chosen can be compared with the

value of that indicator in that jurisdiction at the time of peak

of the previous national cycle. This comparison of economic

cycles consequently makes no allowance for geographical variations in timing. Aid timed to the national cycle may be mistimed

with respect to local cycles.

Deviations from Previous Local Peak Value. A modification

of the approach described above is to use the difference between

the current value and the previous peak value regardless of when

the local peak was reached. This method does allow for interarea variations in cyclical timing. Neither method, however,

separates cyclical from long-term changes in the value of the

indicator. To make this distinction would require separate

analyses of indicator trends and cycles in each potential recipient jurisdiction.

Deviations from Local Trend Indicators. The most effective

method, but the one most difficult to implement, is to use the

difference between the actual value of the indicator and its

projected trend value or its potential value as the measure of

the severity of the downturn. An example of such an indicator

would be a temporary decline in the rate of growth of income.

This would indicate a decline in the region's share of national

economic activity and probably a decline in per capita income

even though no absolute decline in total income had occurred.

This approach would separate cyclical from structural changes in

the area's economic activity, with the latter being represented

by a long-term decline in growth.

Distributing Aid

Considerations in Choosing a Method. Both the economic and

fiscal stabilization goals suggest that the aid-distribution

formula incorporate local indicators of cyclical impact. If

economic stimulation is the major goal, distributing aid to an

area with labor or capital shortages will not generate much

15
new income and employment. If state and local budgetary stabilization is the major goal, by definition the formula should

respond to local conditions.

Several practical considerations complicate local targeting.

For example, the neediest jurisdictions may not be those in a

position to undertake countercyclical projects. An area with

high unemployment may have an unskilled labor force that is

unsuited to a public works project. Or an area with fiscal

difficulties may not have the personnel to draw up plans for a

project; this would lead to delays in implementation.

A second consideration is that the limited availability of

timely data on local cyclical phenomena restricts the possibilities for designing a highly responsive system of local

targeting.

The alternative methods for distributing aid are combinations of a triggering device and a formula to determine local

entitlement. Aid can either be triggered by a national indicator

and then the national total of funds available distributed among

areas according to need, or it can be started and stopped for

each locality individually—in which case triggering and targeting are the same process.

Local entitlement can be determined in one of two ways:

aid can be related to a measure of the severity of the local

cyclical problem, or it can be distributed without regard to

cyclical conditions. Using the second distribution method, aid

can be allocated according to the pattern of another, noncyclical

federal grant, or it can be allocated on the basis of local

features such as selected population characteristics.

National Triggering. Base Grant Distribution. If countercyclical aid takes the form of a temporary increase in the level

of funding of a regular grant program, the simplest method of

distributing the increase is to use the regular grant formula

without modification for cyclical conditions or some other

criterion such as population or population composition. The

resulting distribution would bear no relationship to the severity

of the cycle's effects in any given area, except insofar as those

effects happened to be reflected in the base grant formula, if

16
that were used. 2j The percent increase in the regular grant

would be determined either by an explicit legislative decision or

by the operation of a national triggering formula for the base

grant.

National Triggering. Independent Distribution. Under this

method, the countercyclical portion of aid is distributed by

adjusting the amount called for by the regular formula according

to a cyclical indicator. The ARFA formula, which distributes aid

in proportion to the product of each recipient jurisdiction's

regular (GRS) grant and that jurisdiction's unemployment rate in

excess of 4.5 percent, provides a prototype for this approach, jj/

Since the total amount of countercyclical aid is fixed, the share

going to each jurisdiction is determined by the severity of

unemployment in that jurisdiction relative to its severity

elsewhere, not by the absolute magnitude of the problem.

The countercyclical component could be allowed to become

negative, reducing the GRS entitlement for jursidictions with

very low unemployment rates. This device would be one method of

carrying out a policy of using reductions in federal aid to

dampen aggregate demand in areas with tight local resource

markets.

A variant of this approach is to use data on cyclical

conditions to distribute aid among states; the states would take

charge of distributing the funds to localities. Since some

states have better data on local economic and fiscal conditions

than are available to federal officials, this technique could

improve the intrastate targeting of aid if states are able

and willing to undertake this task.

2/ Income is one of the factors used in the General Revenue

Sharing (GRS) formula. Thus, if this formula were used to

to target countercyclical aid, some of the effect of local

cyclical conditions would be incorporated. As Chapter IV

explains, however, many noncyclical factors also influence

income.

_3/ A certain rate of unemployment—usually 4.5 percent—is

expected to persist. The term "full employment," therefore

often implies a "structural" element of some unemployment.

17
Local Triggering, Base Grant Distribution. A local cyclical indicator, such as the unemployment rate, can be included

among the factors in the regular aid-distribution formula.

A mechanism for countercyclical distribution is thus built into

the basic grant. The redistributive effect is independent of the

national triggering mechanism. Even if no extra aid were provided in response to the national cyclical indicator, the formula

would continue to redistribute funds in response to local cyclical conditions as long as the cyclical component of the grant

were allowed to become negative for areas with low unemployment.

One drawback of this method would be the great uncertainty about

the total funding level required for the countercyclical grant.

Local Triggering. Independent Distribution. The final

alternative is to distribute countercyclical funds without regard

to the distribution of a regular grant but rather according to

the severity of cyclical problems in each jurisdiction. This

would entail the use of a subnational triggering formula incorporating indicators of the severity of the cycle in each jurisdiction and other characteristics of the jurisdiction.

Depending on the choice of a cyclical indicator, additional

measures of local characteristics in the formula might be necessary. For instance, funds cannot be allocated solely according

to an excess unemployment rate. To do so would mean giving the

same amount of aid to a city of 50,000 and to a city of one

million if both cities had an unemployment rate of 7 percent. It

does make sense, however, to give the same amount per capita to

both cities. Including population size in the formula would

accomplish this. Other possible scaling factors include numbers

of people in specific population categories—for example, the

number of school children in the case of an education grant, or

the number of poor people, or numbers of long-term unemployed—or

fiscal variables, such as the volume of state or local own

revenues or outlays.

18
CHAPTER IV. NATIONAL AND LOCAL CYCLICAL INDICATORS

How useful would alternative cyclical indicators be as

triggering and targeting devices in an aid formula?

The proper choice of an indicator depends in part on

the goal of policy. One objective can be to reduce real economic

fluctuations. Another can be to improve the fiscal position

of state and local governments. A third can be to reduce or

avert pressures on prices.

Four characteristics are desirable in a triggering and

targeting indicator:

o It should be a good measure of the problem being controlled;

o It should be available for potential recipient localities;

o It should be available promptly and both nationally and

locally; and

o Its changes should coincide with changes in overall

economic activity so that policy will respond to true,

sustained declines; that is, it should be a coincident

indicator.

INDICATORS OF EMPLOYMENT. INCOME. AND OUTPUT

Unemployment Rate

Triggering. The national unemployment rate is an available,

reliable, and valid indicator of national recession. _!_/ Data are

_!/ This is a controversial point. For further discussion

of the shortcomings of unemployment rates, see J. Shiskin,

"Employment and Unemployment: The Doughnut or the Hole?"

Monthly Labor Review 99:2 (February 1976), pp. 3-10.

19

35-946 O - 78 - 5
published monthly with only a one-month lag, and rate changes

coincide with changes in overall economic activity. Reasonably

reliable unemployment data are also available for many states,

labor market areas, and large urban areas. This consideration

makes possible the use of consistent indicators for the triggering and distributional phases of the funds-allocation

process.

The unemployment rate is not, however, a complete measure

of the employment loss or the economic loss associated with a

recession. Discouraged workers who stop searching for work and

those involuntarily working part-time or below their skill

level—the so-called "underemployed"—are not reflected in the

unemployment rate. Determining what fraction of the unemployed

are jobless for cyclical rather than long-term (structural) and

short-term (frictional) reasons is also a problem. Unemployment

of 4 to 6 percent has generally been considered a situation not

attributable to cyclical causes, while unemployment over this

threshold is deemed cyclical.

Despite its deficiencies as an indicator, the unemployment

rate may still be an adequate measure for policy control. When

the number of persons officially counted as unemployed rises,

the number of unemployed persons under-counted probably goes up

at a similar rate.

Targeting. The attribute that makes unemployment data

attractive for use in the subnational distribution formula

is the availability of unemployment estimates for approximately

1,500 jurisdictions, including all 50 states and all local

governments or consortia designated as CETA prime sponsors.

The reliability of estimates for smaller jurisdictions is considered very low, however.

The recent countercyclical programs all use unemployment

rates or numbers of unemployed persons as indicators of jurisdictions' cyclical needs. The indicator used in the ARFA formula

is the unemployment rate in excess of 4.5 percent. The two

indicators considered in apportioning LPW funds among the states

are the total number of unemployed persons and the number in

excess of 6.5 percent. The three indicators that determine the

allocation of CETA/PSE (Title VI) funds among prime sponsors are

the total number of unemployed persons, the number of unemployed

residing in areas where the unemployment rate exceeds 6.5 percent, and the number of unemployed in excess of 4.5 percent.

20
Table 1 compares two methods of quantifying the severity

of cyclical unemployment in each state. In all cases, cyclical

unemployment is measured as of the second quarter of 1975, the

time when national unemployment reached its highest level

during the last recession; thus, none of these methods allows

for differences in the timing of local cycles to emerge.

As the table makes clear, the choice of method dramatically

affects the estimates of the relative severity of the cycle in

each state. The examples are outlined here:

o Using the difference between the actual state unemployment rate and 4.5 percent and 6.0 percent as an indicator. With this method, states such as Alaska or

Louisiana—with high unemployment both before and during

the recession—would receive the same treatment as a

state like Oklahoma, where unemployment more than doubled

during the recession. Assuming that the timing of the

local cycles coincided with that of the national cycle,

this formula appears not to differentiate between

structurally and cyclically troubled areas. The fixedbase method of computation yields low estimates of

cyclical unemployment in states that had low rates of

unemployment before the recession. This effect is accentuated by setting the uniform base rate at 6.0 rather

than 4.5 percent. The higher the base rate chosen, the

fewer jurisdictions receive aid.

o Using the difference between the actual rate and the rate

at the previous national cycle peak as an indicator.

This method yields much higher estimates of cyclical

impact for the states with low unemployment during the

pre-recession period. For example, New York and North

Carolina reached the same unemployment rate during the

recession, but New York's pre-recession rate was higher.

The two computations outlined in the previous paragraph

implied that the cycle had the same impact on each state,

but the third method shows that North Carolina sustained

much more cyclical damage.

21
TABLE 1. AID TRIGGERS DERIVED FROM DIFFERENT COMPUTATIONS OF UNEMPLOYMENT CAUSED BY RECESSION, BY STATE

Unemployment Rates

State

Alabama

Alaska

Arizona

Arkansas

California

Colorado

Connecticut

Delaware

Florida

Georgia

Hawaii

Idaho

Illinois

Indiana

Iowa

Kansas

Kentucky

Louisiana

Maine

Maryland

Massachusetts

Michigan

Minnesota

Mississippi

Missouri

Montana

Nebraska

Nevada

New Hampshire

New Jersey

New Mexico

New York

North Carolina

1973:III(U ) a/

o —

4.5

6.8

4.8

3.9

6.8

4.1

6.3

4.8

4.8

4.1

7.4

4.9

4.2

4.3

1.9

2.8

3.3

6.8

5.3

4.0

5.8

5.3

3.9

3.8

3.7

3.9

1.8

5.4

4.8

5.3

7.4

5.5

3.3

1975:II(U1) W

7.9

6.9

12.7

10.3

9.9

6.9

8.9

10.2

11.2

8.7

7.5

6.4

7.4

9.3

4.4

4.5

7.7

7.5

10.7

7.2

11.7

13.4

6.2

9.2

6.8

6.4

3.9

9.8

10.0

11.6

10.5

8.9

8.9

Possible Triggering Thresholds

U1-4.5 c/

3.4

2.4

8.2

5.8

5.4

2.4

4.4

5.7

6.7

4.2

3.0

1.9

2.9

4.9

-0.1

0.0

3.2

3.0

6.2

2.7

7.2

8.9

1.7

4.7

2.3

1.9

-0.6

5.3

5.5

7.1

6.0

4.4

4.4

u^e.o d/

1.9

0.9

6.7

4.3

3.9

0.9

0.9

4.2

5.2

2.7

1.5

0.4

1.4

3.4

-1.6

-1.5

1.7

1.5

4.7

1.2

5.7

7.4

0.2

3.2

0.8

0.4

-2.1

3.8

4.0

5.6

4.5

2.9

2.9

U.-U e/

1 o —

3.4

0.1

7.9

6.4

3.1

2.8

2.6

5.4

6.4

4.6

0.1

1.5

3.2

5.1

2.5

1.7

4.4

0.7

5.4

3.2

5.9

8.1

2.3

5.4

3.1

2.5

2.1

4.4

5.2

6.3

3.1

3.4

5.6

(Continued)
TABLE 1 (Continued)

North Dakota

Ohio

Oklahoma

Oregon

Pennsylvania

Rhode Island

South Carolina

South Dakota

Tennessee

Texas

Utah

Vermont

Virginia

Washington

West Virginia

Wisconsin

Wyoming

2.5

4.2

2.9

5.4

4.6

4.9

4.2

2.3

3.9

4.2

4.1

4.3

3.4

7.6

6.4

3.6

2.8

3.9

9.6

7.3

10.5

8.4

12.5

9.2

3.9

8.9

5.6

6.7

9.8

6.8

9.5

8.5

7.6

4.3

-0.6

5.1

2.8

6.0

3.9

8.0

4.7

-0.6

4.4

1.1

2.2

5.3

2.3

5.0

4.0

3.1

-0.2

-2.1

3.6

1.3

4.5

2.4

6.5

3.2

-2.1

2.9

-0.4

0.7

3.8

0.8

3.5

2.5

1.6

-1.7

1.4

5.4

4.4

5.1

3.8

7.6

5.0

1.6

6.0

1.4

2.6

5.5

3.4

1.9

2.1

4.0

1.5

SOURCES: Unpublished data, U.S. Department of Labor, Bureau of Labor Statistics,and CBO

computations.

_§/ The last national recession began at the third quarter of 1973 (1973:111); this point is

designated U .

Jb/. The last national recession reached its bottom in the second quarter of 1975 (1975:11);

this point is designated U. .

c_/ This threshold is computed as the unemployment rate at U less a "normal" unemployment

rate of 4.5 percent.

d_/ This threshold is computed as the unemployment rate U less a "normal" unemployment

rate of 6.0 percent.

&_/ This threshold is computed as the unemployment rate at U. less unemployment at the

start of the recession, that is U .
The first method—using a fixed base—yields estimates of

relative need that reflect both the cyclical and long-run components of unemployment together. The second method—using a

local base—highlights the cyclical component. Therefore, if

the objective is to design a formula that responds only to

cyclical problems, the second method seems more appropriate.

The data suggest that the effect of using this method would

be to reallocate funds away from the larger, more industrialized

states in the North toward those in the South and the farm belt.

Several other economic indicators convey important dimensions of a recession or a threatened resource shortage that are

not measured by the unemployment rate. While each has certain

advantages over the unemployment rate, each also poses some

serious problems.

Level of Employment as an Indicator

With this indicator, there is no need to set an arbitrary

full-employment rate. The employment level can serve as a

measure of growth and job creation potential in the economy since

it shows how rapidly the economy can provide jobs for a growing

labor force. Employment levels are available monthly, local data

exist, and employment changes coincide with changes in overall

economic activity.

Because of labor-force growth, however, a fairly severe

recession could occur, leaving several million persons unemployed, without necessarily producing a decline in absolute

employment. When using this indicator either as a triggering or

as a targeting mechanism, therefore, it should be compared with a

long-run employment growth trend line so that cyclical deviations

can be measured.

Real Wages and Salaries as an Indicator

The real monthly wage bill is the mathematical product of

the number of persons employed, the average number of hours

worked per worker per month, and the hourly wage rate adjusted

for inflation using the consumer price index. Wages and salaries

are the largest component of personal income net of transfers (74

percent) and the most likely to respond cyclically. Recessionrelated reductions and demand-related increases in wage rates and

24
hours worked would be reflected in a wage and salary indicator,

whereas only reductions or increases in the number of persons

working are reflected in the employment measures. Although

changes in wages and salaries measure another aspect of the

economic loss due to a recession, achieving agreement on the

expected long-run growth path of real wage rates and work hours

in a full-employment economy might pose difficulties. In addition, this indicator responds to inflation, labor strikes, and

contract settlements. Thus, these effects would have to be

extracted before this indicator could be used.

Income and wage and salary measures are published quarterly

for states and annually for large metropolitan areas. _2/ Changes

in income coincide with changes in general economic activity.

Real GNP and the GNP Gap as an Indicator

The broadest measure of a recession's effect on economic

output is the decline in the real Gross National Product (GNP)

below its full-employment level. This difference is known as the

GNP gap.

The real GNP gap has three shortcomings as a trigger:

the initial published estimates are preliminary and are often

subject to substantial revision; state or local figures are not

available; and considerable controversy exists over the calculation of potential GNP and thus the GNP gap. _3/ Thus, with this

indicator there would be long lags in the availability of data,

little responsiveness to changing conditions, and no sensitivity

to local conditions. GNP figures do, however, display changes

that coincide with general economic activity.

27 At the substate level, the data are for Standard Metropolitan

Statistical Areas (SMSAs), a designation used by the U.S.

Department of Housing and Urban Development.

_3/ Estimates of potential GNP vary according to the underlying assumptions concerning the natural rate of unemployment, productivity growth, and growth in the potential labor

force. The more optimistic the estimates of these variables, the higher the estimate of potential GNPt

25
The Index of Industrial Production as an Indicator

Another output indicator that has the advantage of monthly

availability and is also a coincident indicator is the Federal

Reserve Board's index of industrial production. This index is

only a partial measure of economic activity, but it covers the

sensitive manufacturing, mining, and utilities sectors of the

economy. No state or local data or ready-made base for cyclical

comparisons is available, however.

Other Possible Indicators

Other statistical series that measure significant aspects

of economic activity are the index of part-time employment for

involuntary reasons and the Wharton index of capacity utilization, kj The index of part-time employment is compiled monthly

from the Current Population Survey. A peak in this index tends

to precede the unemployment rate peaks by 3 to 4 months and the

troughs by 10 months, making it an early warning signal. Using

this indicator could increase the likelihood that a grant program

would respond before a true recession was underway. But this

index does not respond until unemployment has passed 6 percent,

which is usually recognized as a recession signal. This feature

in turn reduces the likelihood of a too-rapid response.

The Wharton capacity utilization rate offers a simple

measure of one of the key indicators of the need for antirecessionary and anti-inflationary policy. Each peak in output

(derived from the Federal Reserve industrial production index) is

defined as full industrial capacity or 100 percent, and current

operating rates are measured in relation to this peak. An

advantage of this index is its simplicity. Disadvantages include

the absence of state or regional data, the provisional nature of

capacity estimates (they are continuously revised in response to

output peaks), and the absence of information on the movements of

the index relative to the business cycle.

47 Robert W. Bednarzik, "Involuntary Part-Time Work: A Cyclical

Analysis," Monthly Labor Review (September 1975), pp. 12-17.

26
INDICATORS OF STATE AND LOCAL FISCAL DISTRESS

No suitable indicators of state and local fiscal conditions exist for use in a countercyclical grant formula. The

state/local operating surplus is useful for describing certain

aspects of state and local responses to the cycle, but it is not

itself an acceptable measure because it reflects both the effects

of the cycle on state and local budgets (autonomous component)

and the response of governments to these strains (discretionary

component). The autonomous change in budgetary position is the

component of budgetary disruption. Two different approaches to

isolating and measuring the autonomous changes in state and local

surpluses are outlined below.

Although there are satisfactory approaches to developing

a fiscal distress indicator, lack of timely state and local data

which are comparable across state and local governments makes it

unlikely that one can be implemented.

The Autonomous Change in the State/Local Surplus. The

GAO report on ARFA _5_/ proposes an indicator of budgetary disruption based on econometric estimates of the response of state and

local revenues and selected categories of spending to recessions.

Budgetary disruption during a recession is defined as the sum

of the autonomous recession-induced decreases in state/local

revenue and the autonomous increases in cyclically sensitive

components of state/local spending. This sum is equivalent to

the autonomous decrease in the state/local surplus—that is,

the amount by which the surplus would decrease if states and

localities made no changes in tax rates or service levels to

compensate for their worsened fiscal situations. Thus far, the

method has only been applied to annual state budget data.

The Impact of Recession on the State/Local Budgetary Constraint . An alternative framework for measuring changes in

the fiscal well-being of state and local governments is presented, but not implemented empirically, by Stephen Barro. J5/

This method focuses on year-to-year changes in the relationship

5/ GAO, 1977, Appendix 1, Chapter 5.

bj Stephen Barro, The Urban Impacts of Federal Policies; Vol.

3, Fiscal Conditions, R-2114-KF/HEW (Santa Monica, Ca.:

Rand Corporation, April 1978), p. 54.

27
between the financial resources available to state and local

governments and the demand for state and local outlays. Barro

shows how estimates of the changes in the various revenue and

expenditure factors can be combined into a composite index of

changes in state and local fiscal condition. Such an index could

be used to target countercyclical aid in much the same manner as

the various indicators of recession described above.

Unemployment rates. In the absence of more appropriate and

easily used budget data, the local unemployment rate is used to

identify areas with budgetary as well as economic needs.

The unemployment rate probably serves to identify areas where

revenues are threatened by declines in income, or those that face

recession-related increases in service demands. But using the

unemployment rate to target fiscal aid may result in aiding areas

in a long-term decline but not facing much cyclical hardship.

INDICATORS OF INFLATION AND EXCESS

AGGREGATE DEMAND

Grant reductions would be appropriate as anti-inflationary

tools when inflation combines with a high level of employment or

a small GNP gap. This implies a dual triggering condition that

depends on both the rate of inflation and the degree of tightness

in the economy.

Price Indexes. The principal candidates for an inflationary

indicator are the consumer price index, the producer price

index—formerly the wholesale price index—and the GNP deflator

or selected components of this indicator such as the state-local

price deflator. The first two indexes are available monthly and

the second two quarterly. The consumer price index measures

changes in prices that are paid for goods and services usually

bought by moderate-income families in large urban areas. The

producer price index shows changes in the prices of all goods

produced or imported for sale in commercial transactions in U.S.

primary markets. The GNP deflator is found by dividing currentdollar GNP by GNP in constant dollars and multiplying by 100.

The state and local deflator corrects state and local spending

for price level changes, thus isolating that component of inflation which may originate in this sector.

28
Since 1970 the CPI, the GNP deflator, and the state and local

purchases deflator have generally followed similar paths, but the

PPI displays swings of somewhat greater amplitude (see Figure 1).

Since the inflation rate lags behind changes in general economic

activity, using any of these indicators would mean that the grant

program would not be responsive to changes in employment and

output.

Figure 1.

COMPARISON OF PRICE INDEXES: 1970 THROUGH 1978,

SECOND QUARTER

Index Value Points

2.4

2.2

2.0

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

—— Consumer Price Index

—— Producer Price Index

Gross National Product Price Deflator

-— State and Local Government Price Deflator

i I I i I I I . I

1970 1971 1972 1973 1974 1975

Calendar Years by Quarters

SOURCE: Data Resources Incorporated.

1976 1977 1978

The amount of excess capacity in the economy can most easily

be quantified using the unemployment rate. A triggering condition for grant reductions could be defined as an unemployment

rate less than some sustainable full-employment value. Alternatively, a GNP gap close to zero—perhaps in the range of 1 to 2

percent—would provide the triggering signal.

29

CHAPTER V. SELECTION AND REGULATION OF GRANT RECIPIENTS

How are state and local governments selected to receive

stabilization grants? And how are the uses of grant funds by

recipient governments controlled? This chapter presents options

available to the Congress for accomplishing these tasks.

FEDERAL CONTROL OVER GRANT-FINANCED SPENDING

Targeting aid to certain sectors, areas, and jurisdictions

raises a number of issues in intergovernmental relations that

are not encountered in federal spending which is not focused on

specific areas. This is because the effect of targeted grants

depends on fiscal and programmatic decisions by recipient

governments.

There are advantages in allowing recipients a certain

amount of discretion in determining how federal grant funds are

spent. Detailed federal involvement increases administrative

costs; regulations may disregard local needs and differences

among areas. Thus the freedom of grantees to make certain

spending decisions can make stabilization programs more effective

by allowing prompt responses to economic changes.

There are also disadvantages to allowing grantees freedom

in their spending choices. If localities use federal grant money

to carry on otherwise locally funded activities, or if they delay

spending the funds, the effect can be to reduce the grants'

effectiveness or even to exaggerate the cyclical situation.

Either result undermines economic stabilization.

Two devices can be used to control the use of grant funds-by

recipients:

o Eligibility for grants can be restricted to those

governments whose budget situation and spending responsibilities make them most likely to spend the funds

consistently with federal stabilization goals.

o Uses of funds by grant recipients can be restricted to

assure behavior consistent with stabilization goals.

31
THE SELECTION OF RECIPIENTS FOR COUNTERCYCLICAL GRANTS 

The antirecessionary programs differ from one another in 

the designation of eligible grantees. ARFA distributes funds 

to state governments and general-purpose local governments 

(counties, municipalities, and townships). The CETA/PSE program 

distributes grants to CETA prime sponsors, which are large 

localities or consortia of local governments. LPW grants are 

available to a broad range of local governments, including some 

school districts and other special-purpose units not directly 

eligible for ARFA and CETA/PSE. 

Functional Responsibilities and Types of Spending 

of Different Categories of Jurisdictions 

One determinant of the effect of countercyclical aid is 

the composition of the first round of spending generated by the 

grant. Labor-intensive projects such as public service employment are appropriate tools if the goal is simply to generate 

employment. If the goal is to raise employment and stimulate 

spending at the same time, a grant for a labor-intensive project 

using low- to moderately-paid workers would be appropriate 

because more income means more consumption. In contrast, a 

capital-intensive project using highly-paid workers will generate 

more output but less employment and spending on local consumption 

since construction materials are likely to be purchased outside 

the area. 1./ 

1/	 The size and speed of impact of similar increases in spending on public service employment, public works, and countercyclical revenue sharing on employment, GNP, and budget 

costs are compared in CBO, Temporary Measures to Stimulate 

Employment: An Evaluation of Some Alternatives (1975), 

p. v, and CBO, Short-Run Measures to Stimulate the Economy 

(1977), p , 3. The implications of differences among state 

and local governments are drawn more fully in Chapter VI. 

In that chapter, the major grants to state and local governments are examined in terms of the types of spending they 

support and their effects on economic and fiscal stabilization. For example, if local governments are to be assisted, 

grants for transfer programs would not be as effective as 

other grants due to the limited role of local governments in 

these programs. 

32 
~~~ .. ~_ ._-- -_..- ... .. -_.. . ._-_._ ­•..

Because of significant differences in functional responsibilities among jurisdictions, there would be differences in 

spending likely to be generated by countercyclical aid. Tables 2 

and 3 illustrate the differences in functional responsibilities 

and expenditure mixes between the state and local sectors. The 

major state expenditures are highways, higher education, and 

welfare; primary and secondary education, police and fire protection, and health care and hospitals are the major elements 

of local spending. The state has a large role in operating 

transfer programs and in financing local outlays for such programs. A larger proportion of local government spending is 

devoted to current operations than is the case with state 

governments (see Table 3). 

TABLE 2.	 STATE AND LOCAL DIRECT, GENERAL EXPENDITURES, BY 

FUNCTION: FISCAL YEAR 1975-1976 (IN BILLIONS OF I 

DOLLARS, AND PERCENTS)	 ; ! 

I 

State Governments Local Governments 

Percent of Percent of 

Function Amount Total Amount Total 

Education 

Highways 

Public Welfare 

Health and Hospitals 

Police and Fire Protection 

Sanitation and Sewers 

Parks, Recreation, and 

Natural Resources 

Housing and Urban 

Rehabilitation 

All Other 

25.5 

14.9 

20.2 

9.9 

1.4 

3.6 

0.3 

20.1 

Total 2./	 95.8 

27 

16 

21 

10 

1 

4 

a 

21 

100 

71.7 

9.9 

11.3 

10.8 

12.0 

8.2 

4.9 

2.9 

28.9 

159.7 

45 

6 

7 

7 

8 

5 

3 

2 

18 

100 

SOURCE: U.S. Department of Comme rce, Bur eau of Census, Governmental Finances in 1975-76, Table 7, p. 22. 

2./ Details may not add to totals because of rounding. 

33 

.L.	 f ·,t· · 
TABLE 3. STATE AND LOCAL DIRECT EXPENDITURE, BY CHARACTER AND

OBJECT: FISCAL YEAR 1975-1976 a./ (IN BILLIONS OF

DOLLARS)

Expenditure Category

Current Operation

Capital Outlay

Assistance and Subsidies

Interest on Debt

All Other

State

Amount

68.2

18.0

7.3

4.1

26.5

Governments

Percent of

Total

55

15

6

3

21

Local

Amount

136.2

28.5

5.2

7.5

2.5

Governments

Percent of

Total

76

16

3

4

1

Total 124.1 100 179.9 100

SOURCE: U.S. Department of Commerce, Bureau of Census, Govmental Finances in 1975-76, p. 20.

aj Amounts shown include general and other direct expenditure,

exclusive of insurance benefits and repayments.

Cyclical Sensitivity of State and Local Finances

A second determinant of the impact of countercyclical

grants is the cyclical sensitivity of the recipient's finances.

The government whose revenue base is most eroded or expenditures

most escalated by cyclical conditions is most likely to spend

grant funds rather than turn them into budget surplus.

Nonproperty tax revenues (mainly income and sales taxes)

respond more automatically to changes in economic activity than

does the property tax base. State revenues are more sensitive

than localities in this respect, and those of cities are more

sensitive than are those of other local governments (see Table

4). A heavy dependence on property tax revenues makes a

jurisdiction more sensitive to inflation because, at least in

the short run, tax collections lag behind changes in property

34
values. _2/ Local jurisdictions should thus be harmed more by

inflation than states, and revenues of cities should be harmed

less than those of other types of local units. These statements

must be qualified by the observation that great differences in

fiscal structure exist among states and among localities.

TABLE 4. STATE AND LOCAL REVENUES BY MAJOR SOURCE, FISCAL YEAR 1975-1976:

PERCENTAGE OF GENERAL REVENUE FROM EACH SOURCE

Revenue

Source

Taxes

Property

Other

Total

Charges and

Miscellaneous

Intergovernmental Aid

Federal

State

Total a/

States

1

58

59

12

28

—29

All

Local

34

8

41

16

8

34

43

Counties

31

7

38

17

8

36

45

Cities

26

17

43

18

13

25

40

Town- School

ships District

56

5

61

9

7

21

30

41

1

42

8

7

46

50

Other

Special

Districts

14

1

15

46

20

8

39

SOURCE: U.S. Department of Commerce, Bureau of the Census, Governmental

Finances in 1975-76. Tables 4 and 16, pp. 19 and 29.

aj Total intergovernmental aid includes transfers between local governments; thus, federal plus state aid need not equal total aid.

21 The property tax base is highly responsive to inflation

but various legal barriers slow the ability of localities to

tap this increase. For further discussion and empirical

evidence, see Robert Crider, "The Impact of Inflation on

State and Local Governments," Urban and Regional Development

Series, No. 5 (Columbus, Ohio: Academy for Contemporary

Problems, July 1978), p. 4t

35
The items of state and local expenditures that respond

most sharply to changes in the level of economic activity are

welfare payments and related social services. Responsibilities

for these services are concentrated at the state level in most

states, but they are assigned to counties or cities in a few

important instances, such as welfare payments in New York City.

Differences in the sensitivity of various spending categories to

inflation are difficult to assess.

Although state revenues and expenditures are more sensitive

to recessions than are local revenues and expenditures, states

probably have greater ability to finance current deficits by

borrowing. Since more than half of all state constitutions

forbid operating deficits, however, grants still have an important role to play in state finances.

State and Local Fiscal Responses to Aid

A greater economic impact per dollar of aid can be obtained

by channeling funds to the jurisdictions that will purchase

additional public goods or services, or reduce taxes, rather than

build up their surpluses. The timing of the grantees' responses

is also relevant.

Unfortuantely, very little is known about the fiscal responses of different types of jurisdictions. Most empirical

studies of the effects of aid have focused on the behavior

of the combined state/local sector. _3_/ There have been some

studies of the behavior of local governmental units (especially

school districts and, to a lesser extent, cities) which yielded

relatively high estimates of fiscal substitution, kj As yet

there are no satisfactory analyses of the fiscal responses of

states.

3/ — Gramlich and Galper (1973) found that expenditure responses

varied with the type of grant. Each dollar of revenue

sharing results in $0.43 added spending, while categorical

matching grants augment spending by $0.80 to $0.90 per

dollar. Edward Gramlich and Harvey Galper, "State and

Local Fiscal Behavior and Grant Policy," Brookings Papers

on Economic Activity 1 (1973), pp. 34-36.

4/ For further discussion of this, see Barro, The Urban

Impacts of Federal Policies.

36
A phenomenon that sheds some light on the fiscal response

issue is the rapid buildup of budget surpluses after the last

recession. A large part of this buildup apparently has been

accounted for by the state governments rather than by the localities. _5/ This suggests that countercyclical aid to the states

might be relatively ineffective. During recoveries, such aid

would be likely to accelerate surplus accumulation rather than

to generate increased outlays. During contractions, the federal

grants would support outlays that might otherwise have been

financed by spending down the existing accumulations.

Several aspects of the role of state governments in the

federal/state/local system need to be taken into account in

deciding how the states should participate in a countercyclical

aid program:

The existence of large state-to-local flows implies

that the distinction between countercyclical grants to

states and to localities is not clear cut. In fiscal

year 1975-1976 state grants to localities accounted for

38 percent of all general expenditures of governments and

provided 34 percent of the general revenue of localities.

States could participate in the selection of the specific

projects to be funded with countercyclical aid (especially in the case of construction grants), just as they

do with many regular federal grant programs. Existing

statewide plans for certain categories of public services

could be used as the base for planning countercyclical

activities. And regular state administrative structures

could be used to ensure compliance with the targeting

provisions and other conditions attached to federal

aid.

5J David J. Levin, "Receipts and Expenditures of State and

Local Governments, 1959-1976," Survey of Current Business

Vol. 58, No. 5 (May 1978), pp. 16-17.

37
METHODS FOR LIMITING FISCAL SUBSTITUTION

Fiscal substitution diminishes the effectiveness of the

grant programs as economic stabilizers. When federal funds are

used to fund projects that would otherwise be paid for with local

resources, little countercyclical gain is achieved. The degree

of impairment depends on how the replaced funds are used. The

greatest damage is done if the funds are channeled into surplus

accumulation. In such cases, the stimulative effect is either

eliminated or deferred to a time when it may be less needed.

Less damage is done if grant funds are diverted toward state

or local tax relief, since at least part of each tax-relief

dollar ultimately results in new spending. If funds are shifted

among expenditure categories in response to the aid, the effects

on local employment and output depend on the expenditure categories involved in the shifting. For example, substituting a

labor-intensive project for a capital-intensive project will

increase employment effects.

When economic stabilization is the primary goal of countercyclical aid, the ideal response by grantees is to increase total

spending for designated projects or activities. Earmarking

and grant-matching requirements assure that recipients spend

federal funds for designated purpose. Earmarking and additivity

requirements ensure that grant financed activities do not replace

activities that would otherwise have been undertaken. Matching

requirements, or other rules that make the amount of aid contingent on grantees' spending behavior, can also be imposed.

Earmarking Grant Funds

The critical factor in earmarking is the designation of

activities that would not otherwise have been undertaken by the

recipients. Earmarking countercyclical aid for specific projects

and activities limits the grantees' opportunities to convert such

aid into general revenue. Many federal programs now in effect

constrain the uses of grant funds. These include the large

construction programs, especially those for water treatment

facilities, airports, and mass transit systems. (Chapter VI

reviews these so-called "categorical" programs.)

Tight federal constraint of the spending of grant funds

would probably be feasible. But the start-ups of countercyclical activities would probably be delayed if federal

38
officials had to approve and supervise in detail the use of all

grant funds. And greater administrative costs would be incurred

for both the grantor and grantee.

Requirements for Additivity of Expenditures

Many federal grant programs are designed to restrict

the ability of recipient governments to shift nonfederal

funds away from the grant-assisted activities. The restrictions

include maintenance-of-effort and nonsupplanting rules and

various forms of a requirement that the grantees display incremental expenditure, services, or employment.

The one requirement of this type in the present countercyclical programs is the maintenance of effort provision in

CETA/PSE, Title VI. The regulations for Title VI of CETA

stipulate that public service jobs funded under Title VI of the

act . . . "shall only be in addition to employment that would

otherwise be financed by the prime sponsor without assistance

under the act . . ." and, more specifically, that programs

supported with Title VI funds:

(1) Shall result in an increase in employment opportunities over those which would otherwise be

available;

(2) Shall not result in the displacement of currently

employed workers . . . ;

(3) Shall not impair existing contracts for services

or result in the substitution of Federal funds for

other funds in connection with work that would

otherwise be performed; and

(4) Shall not substitute public service jobs for

existing federally assisted jobs under federally

supported programs other than those under the Act

.... 6/

6/ U.S. Department of Labor, Regulations Governing Programs

under the Comprehensive Employment and Training Act, part

99.34.

39
One problem in attempting to apply such strictures is

measuring the employment that would otherwise be available.

This difficulty is similar to those encountered in defining

threshold values for recession indicators. The Title VI provision, though spelled out at considerable length, provides

no operational definition of the level of activity expected

without grants. It places no direct restrictions on the right

of CETA/PSE grantees to discharge regular workers. In fact,

it specifically affirms their right to use CETA funds to rehire

employees who lost their jobs because of legitimate lay-offs.

Another problem in enforcing such rules is the limitation

they place on grantees' adjustment to cyclical difficulties.

Unless enough federal aid is available to offset the full fiscal

effect of an economic downturn, some adjustment on the part of

the recipient government—either service curtailment or a tax

increase—would be necessary. Requiring that grantees forego

these adjustments as a condition of eligibility would put many

applicants in an untenable position, particularly those without

surpluses to draw on or the capacity to borrow to fill their

revenue gaps.

Requiring that countercyclical aid add to outlays for the

particular program being assisted does not ensure total spending

will increase. The effect of the additivity provisions could be

to shift nonfederal resources from one program to another,

leaving only the illusion of a net additive effect. Determining

what outlays for all of a jurisdiction's programs would have

been, and establishing a maintenance-of-effort requirement for

total outlays, would be even more difficult than making the same

determination for the particular program receiving assistance.

Matching Requirements and

Fiscal Incentives

A matching requirement makes federal aid contingent on the

state or local government's contribution to the project's costs.

This limits substitution in two ways. First, it sets a limit on

the amount of money that can be shifted to other activities by

requiring a local contribution to the aided program. Second, by

lowering the cost to the grantee of the aided activity, it

encourages greater local outlays than would have been made

without the grant. Matching requirements are part of many

ongoing federal grant programs, most notably the transfer payment

40
programs and the large categorical construction grants. But none

of the current countercyclical programs requires matching.

The effectiveness of requiring matching in countercyclical

programs is questionable. In the case of construction grants,

matching requirements might generate additional outlays by some

grantees. On the other hand, some grantees might be deterred

from accepting the federal funds because of the difficulty of

raising the required matching money during a recession. Also,

the usefulness of drawing in local matching money would depend

on the source of that money. If the funds were shifted from

current operations or from non-grant-aided construction projects

to a project with matching requirements, there would be no

net stimulative effect from the local share. Moreover, even

if grantees responded to the matching requirements with net

increases in total spending, much of the stimulative effect of

the Increases would be cancelled out if they had to raise taxes

to obtain the matching funds. The matching strategy might be

most appropriate during recoveries, therefore, when the alternative to spending, for at least some jurisdictions, is to

rebuild depleted surpluses. These surpluses could be drawn into

spending by means of the grant programs.

METHODS FOR INFLUENCING THE

TIMING OF EXPENDITURES

The current antirecessionary programs contain two explicit

provisions concerning timing. The ARFA legislation requires an

assurance from grantees that funds received will be spent within

six months. The LPW legislation requires that on-site labor

begin within 90 days of project approval.

Strictures like these are unlikely to be very effective, and

they could encourage substitution. Neither provision prevents

the labeling of some activity as supported by countercyclical

aid, whereas the true effect of the aid does not occur until

later.

Certain alternative approaches to stimulating prompt uses

of funds could be effective under some circumstances. One

approach, applicable to construction grants and similar discrete

projects, is to make funds payable only for activity completed

within a specified period. In the case of small public works,

this requirement is equivalent to the starting date requirement.

41
A more moderate variant would be to make the rate of federal

reimbursement depend on timing—for example, the fraction of the

cost paid by the federal government could decline from 100

percent in the first two years to, say, 75 percent in the third

year and to only 50 percent thereafter. Such a provision would

need to be accompanied by very strict prohibitions against

substitution.

METHODS OF CONTROLLING THE DISTRIBUTION

OF GRANT BENEFITS

Special provisions can be designed to control grants' effects

both within and among recipient jurisdictions.

Controlling Geographical Spillovers

Spillovers from aid-receiving jurisdictions can occur

at all stages of the income-, output-, and employment-generation

process. Direct effects result from payments to employees,

suppliers, or contractors outside the jurisdiction. Indirect

effects result when primary recipients of grant generated income

spend a portion of their incomes outside the jurisdiction.

A pertinent example of a constraint to control spillovers

in the current antirecessionary programs is the requirement in

CETA/PSE that public service jobs be filled by residents of the

aid-receiving jurisdiction. The effect of this device depends on

how much of the public work force would normally consist of

local residents and on how many of the jobs represent additional

jobs rather than substitution for regular employment.

Constraining spillovers has inherent limitations. First, it

is questionable whether it makes sense to attempt to retain the

benefits of countercyclical grants within jurisdictional boundaries when the jurisdictions in question are integral parts

of larger metropolitan or market areas. Second, any attempt

to restrict geographical spillovers would probably entail some

loss in economic efficiency. Local public agencies and construction contractors would be precluded from seeking the best

workers and the most favorable terms for procurement of materials

and services. Grant-aided projects might suffer delays and

increased costs because of local shortages of suitable materials

or skills. The process of monitoring compliance and approving

42
necessary exceptions to residency and local-procurement constraints would Itself Impede the efficient execution of countercyclical projects.

Controlling the Distribution of Benefits

Among Population Groups

The objective of channeling federal benefits to the groups

most severely affected by recession has motivated the inclusion

in CETA/PSE of detailed provisions defining eligibility for

grant-supported public employment. The number of programs to

which these targeting constraints can reasonably be appended is

small. The distinguishing characteristic of CETA/PSE and other

employment programs in this regard is that their main purpose is

job creation; production of public services is secondary. If

attempts were made to attach similar restrictions to the regular

social services grants, conflicts might arise between the

targeting constraints and the skills required to operate the

programs.

43

CHAPTER VI. POTENTIAL COUNTERCYCLICAL USES OF GRANT PROGRAMS

This chapter describes the potential countercyclical uses

of federal grant programs that aid state and local governments.

The consideration of grant programs for countercyclical use

is limited to large grant programs, with "large" defined for

practical purposes as having estimated outlays of at least

$500 million in fiscal year 1978. Smaller programs are excluded

because countercyclical spending must be on a scale of billions

of dollars to have a significant impact on macroeconomic conditions. Furthermore, programs and program clusters with outlays

of $500 million or more account for more than 90 percent of all

federal aid to the state/local sector.

Grant programs with potential countercyclical uses can be

grouped into four categories:

o Unrestricted grants;

o Grants for capital construction;

o Grants for current services; and

o Grants that support state and local transfer payment

programs.

Most major grant programs are easy to categorize within this

four-way system. The breakdown is useful because the grants in

each category are similar in terms of administration, impact, and

the type of activity supported. The most difficult problem in

applying the categorization concerns the broad block grant

programs—Community Development Block Grants (CDBG) and grants

under the Comprehensive Employment and Training Act (CETA). On

the basis of the kinds of activities they support, these programs

may reasonably be assigned to the capital construction and

current services categories. Both programs, however, also

resemble General Revenue Sharing in that the detailed decisions

about uses of funds are made at the state and local levels.

Thus, they could be considered in the unrestricted grants category. Table 5 presents the categorical breakdown for all federal

grant-in-aid programs as well as the estimated budget authority

and outlays for each in fiscal years 1977 and 1978.

45
TABLE 5. MAJOR FEDERAL GRANT PROGRAMS, ESTIMATES OF BUDGET AUTHORITY AND OUTLAYS, FISCAL YEARS 1978 AND 1979:

IN BILLIONS OF DOLLARS

Estimated

Administering Expenditure

Grant Program

Wastewater Treatment Construction

Airport Construction

Federal Aid Highway Program

Urban Mass Transportation

Local Public Works Program

Community Development Block Grants

Community Services Program a/

Elementary and Secondary Education

Social Services

Human Development a/

Comprehensive Employment and

Training Programs

Unemployment Trust Fund — training

and employment

Agency

EPA

DoT

DoT

DoT

EDA

HUD

CSA

HEW

HEW

HEW

DoL

DoL

Category

Construction

Construction

Construction

Construction,

service

Construction

Construction,

service, broad

block grant

Service

Service

Service

Service

Service

Service

Budget Authority

1978

4.50

0.56

6.65

0.48

4.00

0.57

3.19

2.52

1.52

2.68

0.61

1979

4.20

0.59

7.84

2.36

4.15

0.60

3.46

2.58

1.70

10.18

0.69

Estimated

Outlays

1978

3.20

0.52

6.20

1.92

2.84

2.10

0.66

2.76

2.72

1.43

8.21

0.61

1979

3.40

0.53

7.20

2.25

1.91

2.90

0.59

3.10

2.58

1.65

9.88

0.70

(Continued)
TABLE 5 (Continued)

Grant Program

Health Services and Resources b/

Medicaid

Child Nutrition Programs

Public Assistance

Housing Assistance

Unemployment Trust Fund — unemployment

insurance administration

Law Enforcement Assistance

General Revenue Sharing

Antirecession Fiscal Assistance

Total Major Grant Programs

Administering Expenditure

Agency Category

HEW Service,

construction

HEW Transfer

program

DoA Transfer

program

HEW Transfer

program

HUD Transfer

program

DoL Service

DoJ Service, broad

block grant

Treasury General purpose

Treasury General purpose

Estimated Estimated

Budget Authority Outlays

1978

1.42

10.70

2.50

6.35

31.55

0.89

0.50

6.86

1.40

89.45

1979 1978

0.97 1.34

11.66 10.70

2.70 2.55

6.66 6.75

24.40 2.99

0.95 0.89

0.50 0.57

6.86 6.83

1.33

93.05 67.12

1979

1.08

11.66

2.74

6.66

3.59

0.95

0.54

6.85

0.02

70.76

SOURCE: CBO estimates.

a/ 1979 budget authority and outlays include anticipated legislation.

b_/ Total of accounts: (1) health services; (2) health resources (health care services); and (3) health

resources (education and training).
THE COUNTERCYCLICAL USE OF UNRESTRICTED

GRANTS—GRS AND ARFA

Two large grant programs (GRS) and (ARFA) provide unrestricted grants. GRS was authorized in 1972 for five years and

reauthorized in 1976 for an additional 45 months. Funding for

this program has increased gradually from $5.3 billion in fiscal

year 1972 to the current level of $6.85 billion. The current

funding level is to be maintained for each year of the extension

period. From the standpoint of countercyclical policy, this

stability is desirable because GRS provides a predictable expenditure base about which deliberate cyclical variations can be

generated. ARFA is a countercyclical program closely linked to

GRS. The two could be combined into a regular, permanent program

of countercyclical aid.

The nonrestrictiveness of GRS makes it an ideal instrument

for carrying out the state and local budgetary stabilization (as

opposed to the economic stabilization) goal of federal countercyclical policy. On the other hand, a negative aspect of such

unrestricted grants is that there is little federal control over

their use. This means, first, that the money cannot be targeted

to particular economic sectors or groups of beneficiaries and,

second, that a higher rate of substitution of federal aid funds

for state and local funds is likely. (Chapter V discusses these

disadvantages.)

Triggering and timing the flow of aid over the cycle. The

lack of any federal involvement in specifying how the aid funds

are to be spent, or even in approving the grantees' expenditure

plans, means that countercyclical aid can be made available to

states and localities without administrative delays. A special

source of concern, however, is that the grantees may use unrestricted countercyclical aid to build up their surpluses rather

than to increase spending or reduce their own revenue collections. This is especially likely because state and local spending is set at the start of a budget cycle and cannot easily be

varied. According to Edward Gramlich (1978), this behavior takes

place to such a degree that unrestricted aid becomes a weak

economic stablization tool, at least during the recovery phase of

the business cycle. \_l

I/ Similar results are also reported in a preliminary report

on GRS prepared for the Department of Treasury by Charles

48
GRS can be turned into an automatic countercyclical program

by appending to the basic program a mechanism that varies the

total amount of aid in response to economic conditions. ARFA and

GRS programs can be combined in such a way. The funding level of

the countercyclical component would vary in proportion to the

unemployment rate. Alternative methods of calculating the

countercyclical component of aid are discussed in Chapter III.

Varying the timing of GRS payments rather than the aggregate

level of outlays is another possible way to achieve countercyclical effects. With this approach, payments would be made

before their scheduled dates during periods of economic slack,

and delayed during periods of resource shortage.

Targeting GRS aid to .jurisdictions. The distribution of

GRS funds takes place in stages. Funds are first allocated among

states, then between the state and local sectors, then among

county areas within states, and finally to individual localities.

At each stage factors such as population, tax effort, and per

capita income are taken into account. ARFA funds are distributed

among states and localities by a formula which uses GRS entitlements and unemployment.

THE COUNTERCYCLICAL USE OF CAPITAL

CONSTRUCTION GRANTS

There are six major federal construction grant programs,

with combined 1978 outlays of $18.2 billion (see Table 5).

The first is the explicitly countercyclical LPW program, which

provides funds for nearly all types of local public facilities.

Four programs support specific categories of public "infrastructure" investment—highways, wastewater treatment plants,

mass transit systems, and airports. The last supports urban

development efforts.

_!/ (Continued) F. Adams, Jr., and Dan L. Crippen in conjunction

with the Brookings Institution's Monitoring Studies Group

entitled "The Fiscal Impact of General Revenue Sharing on

Local Governments," p. 37. They found that unusually large

increases in intergovernmental aid are less easily displayed

by local governments and thus show up as temporary additions

to fund balances.

49
Local Public Works

The temporary LPW program Is a possible prototype for a

permanent program of automatically triggered antirecessionary

construction grants. Because the types of projects conducted

under LPW are those that grantees would normally undertake with

their own funds, the rate of substitution of federal grants for

state and local funds can be quite high. ^7 This makes the

program more useful for fiscal stabilization than for economic

stabilization. If the locality's own funds would have come from

borrowing, however, then the grants achieve neither goal.

Timing the flow of aid over the cycle. LPW has several

advantages relative to the categorical construction grants. It

supports more diverse, generally shorter-term and shorter-leadtime projects. It has few time-consuming planning and approval

requirements. And it lends itself to flexible geographical targeting. The LPW program also has several limitations, however,

because of its zero-base level of funding in nonrecessionary

periods. There is no regular flow of grant funds the timing of

which can be altered to achieve a countercyclical effect, and

there is no matching rate to manipulate. Also, there is no way

to exercise fiscal restraint by reducing aid below its regular

level in times of high inflation or scarce resources. To convert

LPW into an automatic stabilizer, it would be necessary to add a

triggering mechanism and establish some system whereby potential

LPW grantees could maintain a periodically updated file of

approved projects ready for initiation in the event of a recession; but this procedure would probably promote substitution.

The Categorical Construction Grants

The four categorical construction grant programs—highways,

wastewater treatment plants, mass transit, and airports—have

several features in common. All four support relatively largescale, long-duration building projects. All involve the federal

government in approving particular projects and plans. And all

provide supplementary financing in the form of matching grants.

2/ See Gramlich (1978), p. 208. There is also a possibility

that the grants are used to finance projects for which

voters have turned down bond issues.

50
The use of public works construction grants to combat

recession (of which the LPW program is only the most recent

example) raises the issue of whether ongoing, regular construction programs could be developed into automatic countercyclical tools. One major advantage of using the regular grants

instead of ad hoc antirecessionary programs is that the long

delays involved in establishing and implementing ad hoc programs

would be avoided. Another advantage is that regular grants

would provide the option to use cutbacks or delays in outlays to

counter inflation. A feature of the programs that enhances their

economic impact is that the large construction grants are for

specific projects that might otherwise not have been undertaken;

thus they are less likely than many other grants to displace

state and local funds.

Because the construction grants are categorical and provide

relatively limited opportunity for fiscal substitution, countercyclical increases in the number or scale of assisted projects

would do little to help the budgetary situation of the grantees.

The grant would provide general-purpose fiscal relief only in

those situations in which grantees were able to substitute

federally funded projects for projects that would otherwise

have been undertaken with state or local funds.

Timing the flow of aid over the cycle. The timing problems

appear to be worse for the large-scale construction programs

than they are for some other categories of public works. When

projects have not been predesigned and preapproved, the lead

times may be substantial in the context of the cycle. Federal

aid could take the form of reductions in the required local share

of project funding rather than increases in the number or scale

of construction projects. This choice would have two effects.

First, it would free local resources for other uses, making

countercyclical grants more effective for fiscal than economic

stabilization. Second, the delays inherent in large-scale

construction projects would be shortened. Varying the federal

share of program financing could provide rapid assistance to

jurisdictions with federally aided programs already underway.

Targeting aid. The characteristics of the categorical

construction grant programs limit the flexibility with which the

federal government could target aid geographically. The degree

of targeting flexibility is inherently less with fewer, bigger

projects than with numerous, dispersed, smaller projects. Also,

since on-site labor is a relatively small component of total

51
costs, only three out of ten jobs generated by a public works

project are likely to be located in the labor market area containing the project site. _3/

The relatively high skill level required in construction

work ill suits construction grant programs for directing benefits

to lower-income households, youths, or the long-term unemployed.

These programs do appear effective in employing minority workers,

however, kj

The federal aid highway program supports continuous, homogeneous projects. In each state in each year, there is some

federally aided highway construction underway that could be

speeded up or slowed down for stabilization purposes. This

element of continuity, together with the relative stability of

funding enjoyed by the highway program over the years, make the

highway grant program more attractive than the other categorical

construction programs as a base for automatic countercyclical

aid.

The wastewater treatment construction grant program already

matches the highway program in scale and may eventually come

to resemble it in the respects mentioned above. As each state

develops its plans and priorities for wastewater treatment,

and as a backlog of approved project plans accumulates, it will

become feasible to alter the level of program funding for

countercyclical purposes. The program is still in its early

years, however, and its development has not yet reached that of

the highway program so far as potential countercyclical uses are

concerned.

Urban mass transportation grants for construction of rail

transit systems tend to be especially inappropriate countercyclical tools since they tend to be of long duration and to have

long start-up times. They are also concentrated in a few places.

SJ Georges Vernez and others, Regional Cycles and Employment

Effects of Public Works Investments. R-2052-EDA (Santa

Monica, Calif.: Rand Corporation, January 1977), p. 161.

kj Georges Vernez and Roger Vaughan, Assessment of Countercyclical Public Works and Public Service Employment Programs. R-2214-EDA (Santa Monica, Calif.: Rand Corporation,

October 1978), forthcoming.

52
As of September 1976, eight cities accounted for three-fourths of

the federal mass transit funds. J5/ Thus, there would be very

little targeting flexibility. For countercyclical purposes the

matching rate could be varied. The remaining capital funds,

which are mainly used for bus purchases, and all the formula

funds, which are mainly used for operating subsidies, can be

allocated more flexibly.

Community Development Block Grants

The final type of categorical construction grants are Community Development Block Grant (CDBG), which for the most part

are distributed on a formula basis. The level of funding for

each grantee is predetermined, and specific projects are chosen

by local officials, subject to federal approval. Many different

types of projects are eligible, including land acquisition and

clearance, public-use construction and improvement, housing

rehabilitation, and relocation. Some CDBG money can also

be used for certain ongoing services and to provide the local

matching funds mandated by other federal grant programs. The

CDBG program itself requires no local matching.

The flexibility allowed to the local governments means

that changes in program funding can have a speedy impact.

Further, because CDBG funds are less narrowly restricted than

other construction grant funds, a larger fraction of CDBG money

will probably replace state and local spending for construction.

However, if these projects would have otherwise been deferred

during economic downturns, the grants will have a cushioning

effect on local capital outlays, which are the most cyclically

volatile components of local expenditures. Thus, the grants may

generate additive spending.

Triggering and timing the flow of aid over the cycle.

Some of the same options exist for adapting CDBG grants for

countercyclical use as are available for the GRS program. Three

possible approaches are: first, to allow the total level of

CDBG funding to vary systematically over the cycle, leaving the

5/ Richard P. Nathan and Paul R. Dommell, "The Cities," in

Joseph A. Pechman, ed, The 1978 Budget; Setting National

Priorities (The Brookings Institution, 1977), pp. 305-306.

53
distribution formula unchanged; second, to augment the basic

grant with a countercyclical add-on (analogous to ARFA); and

third, to incorporate an indicator of the severity of the cycle

(which could be either an economic or a budgetary disruption

measure) into the basic formula. In addition, advance payments

in loan form of CDBG funds could be allowed during recessions.

Targeting aid to jurisdictions. The nature of the CDBG

formula, especially since its revision in 1977, is such that

countercyclical aid based upon it would be strongly targeted

toward urban areas (this is also true of urban mass transportation grants). This would be a desirable characteristic

if urban areas prove in the future, as in the past, to be more

sensitive than other areas to economic cycles. The CDBG program

also provides, at least in theory, for targeting of activities

in low-income sections of urban areas—a feature not shared by

any of the other construction programs.

Regional Economic Development Programs

Federal grant programs aimed at fostering economic development in particular geographical areas can also be used countercyclically. The principal programs in this category are the

economic development assistance programs of the Department of

Commerce, and the Appalachian regional development programs.

Individually, these programs are small (their respective outlays

for fiscal year 1979 are $153 and $274 million). Together,

however, they are of special interest, because the activities

they support are especially attractive for countercyclical

purposes. Aid under these programs goes specifically for projects aimed at generating income and employment, and at enhancing

the long-term economic prospects of localities.

THE COUNTERCYCLICAL USE OF SOCIAL

SERVICES GRANTS

Ten large grant programs, or clusters of programs, account

for $19.2 billion of fiscal year 1978 outlays for the support

of current state and local public services. Eight of the

ten (all but community services and law enforcement assistance)

are human resources programs administered by the Department of

Health, Education, and Welfare and the Department of Labor.

Several programs exhibit some countercyclical effects.

54
Most federal aid for social services is for ongoing activities. Countercyclical variations in aid would therefore be

expected to affect the scope, coverage, and intensity of the

activities aided, but not to determine whether particular types

of services will be provided.

In most social services programs, federal aid covers only a

minor fraction of program financing, with the remainder of the

funds coming from state and local sources. This is especially

true in the areas of education, health services (other than

services for the needy under Medicaid), and law enforcement.

Thus, substantial percentage changes in federal funding, such as

might be desirable for stabilization purposes, may not be

large relative to the overall level of support for the aided

activity. This reduces the value of such projects as stabilization tools.

Most social services grants support activities that are

carried out by state and local jurisdictions directly, using

public employees. This means that the services programs could

have a direct stabilizing effect on the public sector—perhaps by

offsetting recession-induced cutbacks in public employment.

Because the projects are labor-intensive, the initial employment

impact of the services grants will be larger than the impact of a

similar amount spent on construction, of which a good deal will

be spent on capital costs.

Timing the flow of aid over the cycle. Grants for social

services are likely to enter the spending stream considerably

earlier than are grants for capital construction. How the

two categories of grants compare in the timing of their effects on the private economy is less clear, however. The construction grants, though slow to begin, have their initial

impacts in the private sector, while the social services grants

affect the private sector indirectly and with some delay through

the income—consumption mechanism.

Targeting. Many of the services programs provide benefits to particular disadvantaged segments of the population.

The direct effects of cyclical variations in the levels of

funding of these programs would be concentrated on these target

groups, rather than spread over the general population.

The suitability of the social services grants for countercyclical use depends largely upon the characteristics of the

55
individual programs. The community services program, for

example, may be suitable for countercyclical use because it

supports a large number of small-scale short-duration activities

that could reasonably be pursued with temporary countercyclical

funding.

The social services grant program is a promising candidate

for countercyclical applications. It provides closed-ended

matching grants to states for a broad range of services delivered

to the recipients of public assistance transfer payments. The

federal contribution could be varied countercyclically and would

substitute for local funds, leading to fiscal stabilization.

The law enforcement assistance program consists partly

of a broad block grant to states, which could readily be varied

for countercyclical purposes. Some of the activities supported

by the program are relatively short-term in nature (such as,

procurement of equipment and demonstration programs) and would

not suffer from funding on a cyclical basis.

Public service employment programs have the advantages

of creating employment quickly and at relatively low cost

per job and of affording at least some degree of targeting

control to the federal government. The employment training

assistance component of CETA/PSE, which authorizes public service

employment along with other employment and manpower activities,

provides a potential permanent base for an automatic countercyclical program. _6/

THE COUNTERCYCLICAL USE OF GRANTS FOR

TRANSFER PAYMENT PROGRAMS

Four large state/local transfer payment programs are partly

financed with federal grants—public assistance (mainly Aid to

Families with Dependent Children—AFDC) medicaid, housing assistance, and child nutrition. Total federal outlays for these

programs are estimated at $24.7 billion in fiscal year 1979.

]>/ See Congressional Budget Office, CETA Reauthorization Issues

(August 1978), pp. 29-31, and Richard P. Nathan and others,

Monitoring the Public Service Employment Program. vol. II

National Commission for Manpower Policy (1978), pp. 39-140.

56
Public Assistance and Medicaid

The AFDC and medicaid programs have similar characteristics.

Both provide open-ended matching grants to cover a specified

share of the cost of assistance to certain low-income families

(cash grants under AFDC and payments for medical services under

Medicaid).

The federal grant to each state under these programs is the

mathematical product of three variables: the number of eligible

beneficiaries who participate in the program, the average benefit

payment per participant, and the federal share of the program's

cost.

Triggering and Timing Aid Over the Cycle. In principle, a

countercyclical fiscal effect could be obtained by varying any

one or more of the three variables that determine each state's

grant for transfer programs. Realistically, the possibilities

are more limited. Countercyclical variations in per capita

benefit levels, or in eligibility, would make the standard of

living of low-income families the vehicle of fiscal stabilization. However, it might be considered acceptable and appropriate for economic stabilization to extend eligibility for

some or all benefits to those most severely affected by the

cycle—the unemployed who have exhausted or are ineligible for

other forms of assistance. Twenty-seven states include an

unemployed father component in their AFDC plans. Mandating

extension of this relatively small program to all states could

have a countercyclical impact due to the inclusion of intact

families of new entrants who might have cyclically-caused

difficulties finding employment; intact families of unemployed

workers not covered by unemployment insurance; and intact families of unemployment insurance exhaustees. Implementation of

such programs in all states could be desirable on equity grounds

apart from any stabilization benefits, but no fiscal stabilization benefits are likely unless the federal government increases

its contribution to compensate for the added costs of this

mandate. In addition, since the program only accounts for

approximately 6 percent of AFDC payments in those states where it

exists, the impact on spendable income and thus on economic

stabilization is not likely to be large at present program

levels.

Varying the federal share of transfer program costs is

the most practicable use of the programs for state and local

57
budgetary stabilization. Although the federal share varies from

state to state, each state's required matching rate is easily

calculated from a formula based on state per capita income. Tj A

simple countercyclical mechanism could take the form of a number

or fraction, linked to a cyclical indicator such as unemployment,

that modifies the whole set of matching rates.

A more limited version of this approach would be to change

the federal share only with respect to the portion of welfare

and medicaid cost that is attributable to the cycle. The resulting fiscal relief to states and localities would be significant

because the AFDC and medicaid population are highly sensitive to

the business cycle, JJ/

Targeting Aid. The effect of temporary increases in the

federal share would probably be mainly to free state and local

funds for other uses rather than to stimulate increases in total

welfare and medicaid spending. In this respect, the countercyclical use of the AFDC and medicaid grants would be more

effective for fiscal than economic stabilization. To the extent

that some increase in transfer payments did occur, however,

the benefits would be targeted at the low-income population.

This is a result that is difficult to achieve with other types

of countercyclical aid.

Housing Assistance

Federal outlays for housing assistance take a variety

of forms: payments for the operating costs of public housing,

interest rate subsidies under homeownership and rental housing

programs, and, more recently, direct subsidies to participants in

the Section 8 Housing Assistance Payments program (as authorized

by the Housing and Community Development Act of 1974). To alter

housing assistance payments countercyclically, it would be

necessary to vary the number of new commitments (that is, the

Tj For many states there is also a second optional formula

that does not use income.

_8/ Robert Crider, "The Impact of Recession on State and Local

Finance," Urban and Regional Development Series No. 6

(Columbus, Ohio: Academy for Contemporary Problems, July

1978), p. 6.

58
number of units or households subsidized) under the currently

active programs.

The advantage of using housing assistance as the vehicle

for countercyclical aid is that the program, if appropriately

designed, could apply stimulus or restraint to the cyclically

sensitive housing construction industry. Such a policy has its

drawbacks, however; with conventional production subsidy methods,

long-term obligations would be created that would generate

outlays when stimulus was no longer required. Also, housing

production programs typically have long start-up times. Therefore, it would probably be necessary to develop new forms

of stand-by housing programs to obtain the desired effects.

Child Nutrition Programs

The final transfer payment category, child nutrition programs, has little countercyclical potential. In principle, a

countercyclical effect could be obtained by varying the subsidy

rate* There is no apparent rationale for preferring this method

to more general methods of freeing local resources for other

uses.

Supplementary Security Income

Supplemental Security Income (SSI) is not classified as a

grant, but it resembles grant programs in some important respects. It is reasonable to consider it as an alternative

to the other programs discussed in this section.

SSI is a federally administered system of transfer payments

to the aged, blind, and disabled, with a fiscal year 1978 expenditure level of $6 billion. A certain base level of benefits in

each state is 100 percent federally financed, but many states

contribute supplementary funds to the program. The structure of

this program creates the opportunity for the federal government

to provide countercyclical fiscal relief to states by assuming

some of the supplemental costs or to impose fiscal restraint by

shifting some of the costs of the base program to the states. In

view of the trend toward federalization of welfare programs,

however, it is not likely that the latter would be proposed or

enacted into law.

59
SUMMARY AND CONCLUSIONS

There are only a few programs that can be relied upon

to have the desired countercyclical economic impacts, that

can be targeted flexibly, and that can be operated countercyclically without undue sacrifice of the basic program goals.

The list of "best candidates" varies depending on the stress

placed on the economic stabilization versus the fiscal stabilization goals. For economic stabilization, grants should be

earmarked for particular programs and projects. Such grants can

be more readily targeted than broader forms of assistance at

specific economic sectors and population groups and are less

likely to substitute for state and local revenue or to add to

surplus accumulations. For fiscal stabilizaton, unrestricted

aid, broad block grants, and reduced state and local matching

requirements are most appropriate. More specific conclusions

concerning the major categories of grants and individual grant

programs follow.

Unrestricted grants, such as those provided under the GRS

and ARFA programs, are the most readily adaptable for countercyclical use. They can be targeted geographically with great

flexibility, and their use would entail minimal disruption of

state and local programs. In principle, they can be used

countercyclically during periods of both insufficient and excessive aggregate demand. They are better suited for fiscal

stabilization. The high rate of fiscal stabilization expected

in response to unrestricted grants and lack of control over the

allocation of funds among sectors and population groups weakens

their effectiveness as economic stabilizers. Also, the possibility that substantial fractions of unrestricted aid will be

added to state and local accumulated surpluses raises doubts

about the effectiveness of such aid during recovery phases.

Capital construction grants can be used countercyclically

in several ways:

o The economic stabilization goal can be pursued by varying

the amount of grant-aided activity (either the number or

the scale of projects) or by accelerating or delaying

projects.

o The fiscal stabilization goal can be pursued by varying

the state and local matching rate in programs with

matching requirements.

60
o Some of the delay in the impact of construction grant

programs on economic activity would be eliminated by

establishing automatic mechanisms for triggering construction outlays.

o Of the major categorical construction programs, highway

grants are the most feasible to use as automatic stabilizers.

o The current LPW program could serve as a partial prototype for an automatically operating system of construction grants. The diversity, relatively small

scale, and relatively short duration of projects supported by LPW makes that program more suitable for

countercyclical use than the programs of categorical

aid.

The CDBG program is in a different class from other federal

grants that support capital construction. Because of the flexibility available to the grantees in using federal aid, the

program resembles GRS in many respects and has some of the same

advantages and disadvantages as a countercyclical tool.

Social services grants are not practical to use as fiscal

stabilization instruments. The principal reasons are that the

programs are fragmented—they consist of many components with

different formulas and allocation procedures—and that cyclical

fluctuations in program funding could result in unacceptable

disruptions of programs serving particular, usually disadvantaged, target groups. The social services programs that are most

promising as vehicles for countercyclical aid are the community

services grants and both the manpower development and public

service employment (PSE) components of CETA.

Social services grants have the advantages that they can

generate relatively large increments in employment per dollar of

aid, can be targeted, are continuously variable in size, and

involve relatively short time lags. Their disadvantages include

the likelihood of high rates of fiscal substitution and the lack

of direct impact on the private sector of the economy. The PSE

program, which is the largest of the current antirecessionary

programs, could readily be converted into an automatic countercyclical stabilizer. Although PSE is a direct instrument for

stimulating employment, it is especially subject to the problems

of social services grants.

61
Federal grants in support of transfer payment programs

have limited but potentially important countercyclical uses.

It would be possible to provide countercyclical fiscal relief

(or to apply restraint) by varying the required matching rates

under these programs. This would be useful mainly for fiscal

rather than economic stabilization. Federal housing assistance

grants could also be varied countercyclically by adjusting the

number of households assisted in response to economic conditions.

This would have the advantage of directing countercyclical aid to

the volatile housing sector, but under the current housing

programs such action would create undesirable long-term spending

commitments.

62