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Winners and Losers in the Transfer Game

No State Ever Became Rich by Relying on Federal Wealth Transfers

SEPTEMBER 01, 2001 by CHRISTOPHER WESTLEY

I like lists, be they David Letterman’s Top Ten lists, the mainstream historians’ best-presidents lists, or my wife’s honey-do lists. They tell us much about the kind of society in which we live. Frequently, these lists reveal more about whoever compiled them than about whatever data is actually included on them.

One list in particular makes the news every year where I live, and it receives more press than the college football rankings. This list compares the net “donors” and the net “winners” of the transfer game.

This game has become a trillion-plus dollar operation over the years, and it behooves us to know as much about it as possible, because we are all forced to play it. It is morally justified by an egalitarian ideal that is contrary to human nature, and thus requires force to impose it.

This is how it works: The Feds take money from us, keep a portion for themselves, and then give back the remainder in the form of spending projects. States that get more back than they give are called the winner states. States that get less than they give are called donors, thus giving the scheme a charitable aura. (In truth, calling them losers might result in their losing interest in playing.) A Washington, D.C.-area think tank called the Northeast-Midwest Institute www.nemw.org has been compiling lists of the top winner and donor states for several years. They result from studies of each state’s contribution in federal taxes and its take in fiscal spending. This is the transfer system, and it amounts to a zero-sum game: winner states can only win to the extent that the donor states lose. In 1999, my own state of Alabama was ranked tenth among the top ten winners. (See tables below.)

Invariably, the press reports these findings as good news for the winner states. For instance, in Alabama the press bias is that while local culture may be congenitally opposed to a large federal government, the state sure benefits from the system. However, it’s far from clear whether findings such as these are accurate depictions of a state’s fiscal health or its distribution of benefits.

Nobel laureate Milton Friedman once argued that increases in the money supply are distributed in the economy through what he termed “the helicopter effect.” If the Federal Reserve increased the money supply by $1 billion, Friedman said, the increase in money would be spread equally through the country, as though it were dropped from a helicopter at a high altitude.

As any undergraduate money and banking student knows, however, that is not true, and Friedman himself has backed away from this analysis. The newly created money isn’t evenly distributed among the population. Rather, the groups that benefit from the new money are those that receive it first. Usually, by the time the money is spread out across the entire economy, its benefits have been lost because of inflation.

Uneven Distribution

The same is true for fiscal spending as well. Federal spending in the states does not benefit each resident equally. Otherwise, if the results from these studies were to be taken seriously, federal spending in Alabama would be equivalent to each resident receiving a 50 percent federal tax refund. In fact, those individuals who directly receive the money are the actual beneficiaries.

In Alabama, as in most of the winner states, the lion’s share of this surplus goes to the military, benefiting areas of the state that house bases, arms depots, and training and testing facilities. But even in these areas, the economic benefits are not evenly distributed. Rather, they are limited to local firms that directly and indirectly serve these facilities.

Furthermore, if you live in another part of the state that is not affected by military spending, you may not benefit at all—and yet the state rankings imply that you do.

Alabama is likely to move up to a higher ranking next year if only because of the December 2000 storms that devastated the south. Millions of FEMA (Federal Emergency Management Agency) dollars will be added to the regular federal outlays earmarked for the state. If the 1995 Hurricane Opal disaster relief is any guide, the funds will go to construction firms that are politically well connected, not to those in the counties where the destruction actually took place or to organizations on the scene that are best situated to deal with crises at hand. Not only does this practice slow the rebuilding process, it also brings with it hidden costs, such as the squelching of private relief efforts that otherwise would have sprung up and promoted a quicker rebuilding effort.

This is not the type of spending that suggests an improvement in the quality of life, as is implied by these rankings. It only reflects the kind of growth that results from the destruction of capital. This amounts to forced spending that restores the status quo. Unfortunately, these are costs not easily measured by analyses of fiscal spending or easily included in the identification of winners and donors.

Cost of Capital Transfers

Another cost not conducive to measurement is the cost of transferring capital from private uses to those deemed necessary by the federal government. Taxation is simply forced capital spending, or the diversion of money from private uses to those determined by the transfer state. Alabama may receive some benefit from these capital flows, albeit unevenly distributed, but at a cost to donor states such as Connecticut, New Jersey, and Nevada. Individuals have less disposable income in these states to spend on things they deem important, and the money is transferred to support those causes deemed important by the political class. The larger this transfer system gets, the more force is required to maintain it. Certainly, this is a cost that does not make it into the analyses of the efficacy of fiscal spending.

Besides, it is far from clear that being among the nation’s leaders in net federal spending should be a game any state wants to win in the first place. No state ever became rich by depending on federal wealth transfers. Policies that create and attract wealth are no secret. A state becomes wealthy by protecting private property, maintaining a stable system of low taxes, decentralizing its infrastructure, and minimizing intervention in private capital flows. Such policies, from generation to generation, encourage good work habits, higher time preferences, and increased capital from other states where wealth is less secure.

Unfortunately, these are policies that will be pursued by the political classes that inhabit our state capitals only to the extent that they promote the mobilization of voting blocs that ensure the maintenance of power. As a result, economic and political incentives can be at odds with each other. Policies that reward the existing political class in the short run can hinder a state’s ability to develop a legal and economic infrastructure that promotes long-term capital creation and that encourages capital mobility and investment.

Federal spending can become an enemy of such outcomes. Increasing federal funding to the poor states enables them to avoid these reforms, while at the same time it penalizes rich states for implementing them. Why should a state correct for poor policy prescriptions if the federal government compensates for the resulting shortcomings? The long-run consequence of maintaining such a system is a skewing of incentives and a diminution of the ethos of wealth creation that allows states to become wealthy places in the first place.

Federal Dollars Received in Fiscal Spending for Each Dollar Paid in Taxes

Top Ten “Winner” States Top Ten “Donor” States
New Mexico 2.01 Connecticut 0.66
Montana 1.75 New Jersey 0.66
West Virginia 1.74 New Hampshire 0.71
Mississippi 1.71 Nevada 0.74
North Dakota 1.68 Illinois 0.74
Alaska 1.59 Minnesota 0.80
Virginia 1.56 Michigan 0.83
Hawaii 1.52 Delaware 0.84
South Dakota 1.49 Wisconsin 0.85
Alabama 1.49 New York 0.86

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September 2001

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