Intergovernmental grants are a significant part of both federal and state budgets. From the first annual cash grant under the Hatch Act of 1887, the number of grant programs rose to more than 600 in 1995 with outlays of $225 billion, or about 15 percent of total federal spending. Most federal grant programs are small and serve narrow purposes, while a few large programs—such as Medicaid and the Highway Planning and Construction Program—dominate the grant-in-aid system. Of the 633 grants we reviewed, 87 programs—or 14 percent—accounted for 95 percent of total grant funding. In 1995, federal grants accounted for about 23 percent of total state spending. Here too there is variation in the federal share of state spending across categories used by the Census Bureau. Grants accounted for about 60 percent of public welfare and 64 percent of housing and community development spending. The federal share was much smaller in other categories, about 8 percent overall. In theory, grants are to serve purposes beyond returning resources to taxpayers in the form of state services. Grants also can serve as a tool to encourage states to spend federal funds for nationally important activities for which they otherwise would have spent less. The amount of additional spending is affected by the degree to which federal grant funds actually supplement state funds. Public finance literature uses the term substitution to characterize situations in which states use federal grant dollars to reduce their own spending for the aided program either initially or over time. To illustrate how substitution works, if states use federal funds to replace state spending on a dollar-for-dollar basis, then federally aided state services would remain at pre-grant levels—in which case the fiscal impact of the additional federal dollar on the intended program is zero. In practice, substitution effects are not this extreme; total state spending rises upon receiving federal grant funds—but by less than the full amount of the grant because states reduce their own spending for the area. In effect, substitution allows a portion of federal grant funds to be spent on other state priorities. Figure 1 illustrates how substitution would work for a hypothetical state spending $5 on an activity and receiving $1 in federal grant funds for that activity. As previously noted, federal grant dollars are rarely used dollar-for-dollar to supplement state spending on aided activities. However, we show this case in the top part of the figure as a contrast to the expenditure level that might result when substitution occurs. We show substitution at 60 cents to correspond to the approximate midpoint of the range of estimates we reviewed. The figure indicates that with substitution, although the federal grant dollar is spent on the aided program, the state can reduce its own spending by about 60 cents so that total spending increases by 40 cents. The state can then reallocate the 60 cents that has been freed up. In this regard, the figure shows the two options cited by economists—spending on other state priorities or tax relief. For example, states could spend their freed up funds for other public goods they value, such as education, transportation, or corrections. Or, states could reduce or maintain existing tax rates or slow the rate of increase. As noted, there are a variety of approaches available to distribute grants among the states. Public finance experts suggest that grants can be targeted to states with relatively greater programmatic needs and fewer fiscal resources. In program areas where states share financing responsibilities with the federal government, service levels depend to an important extent on state fiscal capacities. For example, after adjusting for differences in state service costs, the fiscal burden on Mississippi of providing a given level of public services is greater than the burden on Connecticut because Mississippi has about three-fourths the tax base of Connecticut. Where the federal government has sought a minimum or more comparable level of a service for all potential beneficiaries— regardless of where they live—grants can help reduce disparities between the capacities of wealthier and poorer communities to provide that service. Our past studies of individual grant programs have led us to conclude that grants can be designed to reduce differences between states’ fiscal resources and programmatic needs by designing formulas that allocate funds according to measures of states’ program needs, fiscal capacities, and service costs. In those studies, we also commented on the importance of using data that accurately capture differences in these factors across states. The objectives examined in this report are those most often put forward by public finance experts: (1) encouraging states to spend more for public goods that appear underfunded from a national perspective, and (2) offsetting the differences between states’ programmatic needs in federally aided functions and their fiscal resources. Grants have played other roles in intergovernmental relations as well. For example, grants have been used to provide states with (1) funding to offset the costs of meeting federal regulatory standards or administering federal regulatory programs, (2) counter-cyclical assistance in times of economic downturns, (3) general purpose fiscal assistance (e.g., general revenue sharing), and (4) performance incentives to improve or enhance existing programs. Appendix I contains a more detailed discussion of the various roles grants have played. To examine substitution in the grant system, we synthesized the body of econometric literature which statistically isolated the fiscal impact of federal grant funds and estimated their impact on total spending. We used this approach because conventional auditing methods were not sufficient to answer the questions about substitution. Such methods do not control for state spending that would have occurred without a federal grant and cannot sort out the effects of other factors, such as population and state income growth, that also influence state spending. Thus, an audit of a federal grant program might demonstrate that all federal funds were spent on the authorized activities. However, because the audit could not observe the level of state spending that would have occurred without the grant, it could not detect substitution in the form of reductions from that unobserved level. To examine targeting in the grant system, we developed a statistical model to determine the extent to which federal aid in the aggregate is allocated to offset differences between state programmatic needs and fiscal resources (see appendix IV for a description of this model). We did not analyze targeting for individual grant programs because there is less consensus on—and few readily available and suitable proxies for—measures of individual grant program needs and costs. For this reason, our prior work on federal grant targeting has proceeded using a program-by-program approach, with each case study requiring substantial work to identify and validate suitable proxies for state programmatic needs and costs. For this report, our model used state population as the primary measure of state programmatic need. The model also controlled for a variety of other state need indicators, such as measures of poverty, housing age, highway mileage, and service costs. Controlling for programmatic needs and costs enabled us to isolate more accurately the statistical effect of state fiscal capacities on federal grant allocations. In addition to this statistical analysis, our examination of substitution and targeting included (1) a comprehensive review of over 120 journal articles, reports, and econometric studies on substitution, targeting, and grant design factors related to both, (2) a synthesis of 50 econometric studies of federal grants, culminating in the development of point and range estimates of fiscal impact overall as well as for different time periods and grant designs, (3) a review of 23 GAO reports on options to achieve greater targeting in specific formula grant programs, and (4) an analysis of grants for design features associated with substitution and targeting. Our analysis of the design features associated with fiscal substitution was for both all 633 grants and separately for the largest 87 programs representing 95 percent of grant funds. Our analysis of the design features associated with targeting was for the 149 formula grants that represented 85 percent of grant funds. We excluded project grants, which are awarded on a discretionary basis, because of the difficulty of generalizing about targeting based on individual grant decisions. Because grant implementation issues were outside the scope of our analysis, this report cannot be used to draw conclusions about how well a jurisdiction uses grant funds or who benefits. In addition to design features, two important determinants of a grant’s fiscal impact are states’ priorities, which may differ from the federal government’s, and program management, which may differ across states. To illustrate, a grant for computer education programs might feature few of the design features to limit substitution, but shared goals and objectives could result in states using the grant funds they receive to increase substantially total spending on computer education. Or, a grant for health services to low-income children could lack equity factors that target funds to states with higher concentrations of such children. Notwithstanding the lack of targeting, however, a state could still spend more of each federal assistance dollar it receives to serve its low-income children than another state receiving more grant funds. Just as the presence of suitable design features does not guarantee that funds will be allocated efficiently or equitably, so the absence of such features alone does not prove that they are not. We asked well-known public finance experts as well as experts on state and local government to review a draft of this report and incorporated their suggestions where appropriate. Appendix II contains a more detailed description of our scope and methodology. The economic literature we reviewed suggested that three types of grant design features affect the likelihood that states will use federal funds to supplement, rather than replace, their own spending. These features work by (1) restricting the use of funds to specified purposes, (2) requiring recipients to contribute their own funds to obtain grant funds, and (3) not restricting federal matching of state funds. The first type of feature concerns the extent to which grant purposes are restricted. Categorical grants, which fund narrow-purpose activities, such as nutrition for the elderly, are the most restricted. Block grants, which fund broader categories of activities, such as community development, are less restricted. General purpose grants, such as revenue sharing, require only that the funds be spent for government purposes. Generally speaking, experts agree that conditions attached to aid can encourage states to use federal funds as a supplement if the conditions are binding.