6. Fiscal Illusion
Fiscal evasion—avoiding the rules meant to constrain spending—has been sustained in New Jersey, in part, through fiscal illusion. The full costs of spending have been partially obscured by the state’s reliance on debt and intergovernmental aid.
In a federal system, a resident falls under the jurisdiction of multiple levels of government. In the United States, a resident is under the jurisdiction of the federal government, a state government, a county, and possibly a municipality. These jurisdictions rely on the same taxpayers to function. The risk is that multiple layers of government exhaust the same tax base. The way to limit this risk is through competition at all levels of government.
Every jurisdiction in a federal system offers a range of public goods and services paid for by taxpayers. Jurisdictions compete for taxpayer dollars through the level of taxation and mix of goods and services they provide. When governments make poor fiscal choices or under- or over-provide certain goods, elected officials may be voted out of office, but taxpayers may also choose to “vote with their feet,” and move to locations which offer a different mix of goods and services at a different price.
The three crucial conditions for interjurisdictional competition are: the political autonomy of lower levels of government, the free movement of goods and people, and the absence of aid transfers from higher to lower levels of government. When these three conditions are met, they create a “market-preserving” federal system, which uses taxpayer preferences to constrain elected officials’ choices.
The rules that constrain government through competition are vital to maintaining the market-preserving system of federalism, as they make government commitments credible to taxpayers. When the rules maintaining a federalist structure are weakened, so are the checks on government, and socially destructive policies favoring narrow interest groups can be more easily implemented.
During the 20th century, federal mandates and aid transfers have weakened one of the auxiliary precautions necessary to federalism—interjurisdictional competition. Mandates impose policies and often pass on the costs of such policies to recipient governments. Federal transfers erode state and local policy autonomy by inducing further spending or directing state and local resources to areas that may not need it. New Jersey’s political and fiscal autonomy has been eroded by the growth of federal grants-in-aid and unfunded mandates. This is repeated on the local level, with state aid acting to erode competition among New Jersey’s municipalities.
6.A. Federal Funding
Twenty-seven percent of New Jersey’s budget is dedicated to federal grants-in-aid. Grants-in-aid are the policy priorities of the federal government, but they are administered by the state (and local) government.
Grants-in-aid have several important features. First, a federal grant affects how states choose what goods to provide and in what amount, and may lead to the over- or under-provision of goods actually demanded by state (or local) citizens.
Secondly, federal grants allow state and local beneficiaries to spread program costs across all federal taxpayers. Since state and local recipients of federal grants do not bear the full costs of program spending up front, they perceive the costs of public spending differently and may demand more spending than they otherwise would. In essence, the source of taxation (federal revenues) and the place of spending (state and local beneficiaries) are separated, leading to “grant illusion.” Further, when federal funds are used to augment state or local budgets, they act to “bail out” the lower level of government, softening the “hard budget constraint,” thus dulling (or even encouraging) the consequences of poor fiscal choices on the state and local level.
Grants weaken state and local political autonomy. When the state accepts federal funding, it is engaged in a contract with the federal government and must adhere to the conditions the grant imposes. One condition attached to some grants is the matching requirement, which stipulates that states commit some of their own resources as a condition of receiving federal aid. The purpose is that states supplement, rather than substitute, their funds for designated activities. The matching requirement has an unintended effect. In order to qualify for federal funding, states dedicate more resources than they otherwise would have to areas where there isn’t much need, leaving other areas under-funded.
Medicaid is a matching grant. It is also the most significant and fastest growing federal program, representing 9 percent of the state’s budget. It was created in 1965 to cover basic health care and long-term services for low-income individuals, the elderly, and the disabled. New Jersey began participating in 1970, the last state to do so. New Jersey must match 41.22 percent of the costs of the program, with the federal government contributing the balance. Of New Jersey’s 8.5 million residents, 997,300 participate in the program, costing roughly $9 billion in FY 2009, of which New Jersey contributed $3.56 billion.
To receive federal funds, states must agree to offer certain services. States control their level of participation by opting in or out of additional services. Medicaid is, in effect, 50 distinct programs in the United States, depending upon which options each state chooses to provide. At least one federal law increased eligibility or expanded benefits each year between 1984 and 1991, which, in addition to demographic changes, increased the program’s costs to the federal and state governments.
New Jersey participates in most of these expanded provisions and has the highest income threshold maximum for child eligibility, making it one of the most costly Medicaid programs in the nation. Between 1995 and 2000, New Jersey’s Medicaid expenses grew only two percent, compared to five percent nationally. However, in 2000, Medicaid costs rose by 12 percent, leading to an enrollment freeze on adult coverage. Since that time, costs have risen about seven percent a year. Rising health care costs and a state campaign to expand coverage increased the number of recipients by 37 percent between 1990 and 1995. State spending on Medicaid doubled from $1.8 billion in 1996 to $3.34 billion in 2007.
Congressional passage of the State Children’s Health Insurance Program (SCHIP) in 1997 has added to New Jersey’s growing health-care budget. New Jersey operates “one of the most generous SCHIP programs in the nation,” expanding coverage to children up to 350 percent of the poverty level—becoming one of a few states to cover parents (with federal dollars) and single adults (with state dollars). In 2001, New Jersey expanded SCHIP again, permitting coverage—funded with state dollars—for single adults with incomes at or below 100 percent of the federal poverty level. New enrollment was frozen in 2002. As the economy began recovering in 2004 and 2005, the state began a new program of encouraging Medicaid/SCHIP enrollment.
Since state governments cannot run deficits, when Medicaid (and SCHIP) costs escalate, states have three choices: cut the program, increase taxes, or take money from other programs. The federal stimulus of 2009 provides an additional $1.06 billion for enhanced Medicaid funding in FY 2010. The rationale for this infusion is that it will free up resources for other areas of New Jersey’s budget. But by expanding the program, enrollment will increase and the state will need to spend more to meet the matching requirement, leaving the state with fewer resources to spend in other areas. If Medicaid enrollment does not recede when the federal stimulus funds are spent, New Jersey will be left with a permanently larger Medicaid program to support.
6.A.2. The Federal Stimulus
The effects of federal spending in New Jersey’s budget over the past 40 years are magnified by The American Recovery and Reinvestment Act of 2009 (ARRA). ARRA, meant to help states navigate the recession, directs $17.5 billion to New Jersey ($7.5 billion in tax breaks, and $10 billion in spending). In FY 2010, New Jersey will spend $2.2 billion in stimulus dollars. Over one-third is dedicated to Medicaid. Another $1.05 billion is for spending on education. The remaining 22 percent is for infrastructure and transit projects across the state (figure 6).
The intent of the stimulus is threefold: help states cover budget shortfalls, provide increased assistance to the poor, and jumpstart the economy through government spending for education, transit, and infrastructure projects.
The stimulus is unlikely to achieve these aims. Bailout funds do not address the underlying causes for New Jersey’s eroded fiscal condition. Subsidization only reinforces the practices that created the present crisis. With the current budget, the governor is repeating past mistakes—deferring pension contributions, expanding spending, and raising taxes. The actual cuts to the budget do not bring it anywhere near balance. When stimulus funds recede, New Jersey will need to find a way to support expanded federal programs, a larger pension burden, and new education programs. On the national level, the cost of the stimulus will be paid for in debt—borne by future taxpayers.
As intergovernmental aid, stimulus spending encourages fiscal illusion. Temporary budget balance is achieved in part with federal grants. As discussed, federal grants change behavior on the state level, stimulating spending either through matching requirements, or by allowing states to free up funds to expand spending in other areas, thus increasing the total size of the state budget. Since the stimulus will be paid for in debt, that is, future taxation, the costs of spending are lessened for present beneficiaries. This ultimately erodes accountability for how public funds are spent, weakening the link between beneficiaries and taxpayers, and diminishing citizen voice in how the public sector spends taxpayer funds.
6.B. Municipal Government, Intergovernmental Aid, and State Mandates
The local level also bears the costs of the state government’s fiscal policies. Court mandates on schooling and affordable housing, state-negotiated public pension benefits, and intergovernmental aid to municipalities and school districts change the tax and spending incentives facing local governments. State mandates have steadily increased property taxes while eroding local autonomy in the provision of services and control over the growth of spending on the local level. Just as federal grants-in-aid change the incentives facing state government, the Property Tax Relief Fund and state aid programs targeted at the municipal level have the effect of promoting fiscal illusion and subsidizing inefficiencies in local budgets.
New Jersey has the second highest level of property tax per capita in the United States, an average of $6,787. The property tax’s steady increase, 7 percent a year on average (see figure 7), has been the source of citizen discontent and likely one of the drivers behind New Jersey’s loss of 377,000 people between 2000 and 2006.
The variety of corporate forms and number of municipalities in New Jersey is an outgrowth of the state’s population growth and economic development during the 19th and early 20th century. Municipal incorporation served as a means of private zoning and a means of settling disputes over tax rates, the use of revenues, or control over private activity. Municipal creation boomed between 1834 and 1957, their number increasing from 125 to 568, as “citizens sought to meet the problems of local government in growth areas by creating new governmental units.” Described as “largely a series of declaration of independence,” an average of five new municipalities were added every year between 1840 and 1920. The 1926 decision by the U.S. Supreme Court to allow local governments to use zoning to determine land use “rendered moot the option of creating a new municipality.” By the 1950s, the total number of municipalities remained set at 567.
The advent of zoning was followed by a major fiscal stress test of local budgeting practices. During the Great Depression, many New Jersey municipalities, along with the rest of the nation, saw a significant drop in economic activity and thus revenues, leading 87 municipalities and 2 counties to default. By 1936, 8 municipalities recovered as public projects were cancelled, 28 municipalities were paying in scrip, and 12 towns were insolvent.
While municipal default was driven by an unprecedented collapse in revenues, many towns faced structural budgetary problems due to accounting practices, such as overstating revenues to conceal their debts. The state called for reform, requiring municipalities to adopt cash budgets.
Significantly, state-administered municipal aid programs were expanded. The state gradually began to take over the levying and distribution of local revenue sources. The intent was to rescue and stabilize local governments, but in doing so, the state helped to weaken the “hard budget constraint” facing municipalities, laying the groundwork for future municipal dependencies and inefficiencies. Municipalities could now budget under the promise of aid, rather than the penalty of potential default. Revenue-sharing and redistribution arrangements also produce other unintended fiscal effects. By homogenizing municipal budgets and policies, state aid weakens competition among local governments, which compete for citizens by offering different mixes of goods and taxes. This expansion of state aid also provided an opportunity for the state to funnel locally levied and collected revenues into its own coffers.
The process of the state assuming control of local revenue sources and redistributing revenues according to revised formulas continued into the early 1970s. Until the 1960s, municipal governments in New Jersey collected taxes on several sources, including the Business Personal Property Tax and the Financial Business Tax. Both sources of taxation were assumed by the state, which took over the administration and redistribution of the revenues. Part of these formerly local revenues was returned to municipalities, and part retained or “skimmed” by the state. These municipal-aid streams were eventually gathered into the Consolidated Municipal Property Tax Relief program and Energy Tax Receipts program in 1996. The growth of municipal aid continued with the creation of the Property Tax Relief Fund in 1976. In addition, the state operates two other municipal aid programs: Extraordinary Aid—for municipalities under unexpected and exceptional budgetary stress—and Urban Aid—for cities with higher poverty levels suffering from eroded local tax bases. Property tax revenues, on average, make up about 40 to 50 percent of municipalities’ budgets.
Budget caps have failed to control spending in schools, municipalities, and counties. Property tax reform has been on the agenda of the state and municipal governments several times in the past. In 2006, the issue was the subject of a special session of the legislature called by the governor which resulted in multiple hearings, four reports, and 200 recommendations for reform. However, the recommendations of the committee did not make much progress—the commission was disbanded in December 2006—leaving the perennial issue of New Jersey’s rising property taxes unresolved.
The commission, according to some legislators, also failed to consider “critical Constitutional issues, such as which branch of government should control school funding, land use, State debt, and State spending caps… proving that the Joint Committee shunned addressing the real issues that could have produced significant results in terms of reducing or controlling the property tax burden.”
The costs of state mandates vary according to municipality. Mandates cover many areas: environmental protection, schooling, public safety, health, and engineering. The township of Hardyston in Sussex County estimates 77 state or federal mandates are imposed on their budget. The most significant of these are related to pension benefits for police, firemen (0.25/$100 payroll), and teachers, (.0927/$100 of payroll) and insurance costs for municipal employees ($750,000 annually). Federal mandates, such as No Child Left Behind, are also passed down to the local level of government.
Aside from the costs to local taxpayers, mandates compromise the effectiveness of local governments. Municipalities are less responsive to the demands of citizens when they are forced to provide a level of services determined by the state or the federal level. Ideally, services should be provided by the lowest level of government possible where the actions and their costs are most visible to citizens. To what extent individual municipal governments are operating efficiently is unclear, if the design of policy and budgets is intertwined with state policies and aid streams.
Federal aid to the states, state aid to municipal government, and reliance on debt have clouded the full costs of spending to New Jersey’s citizens. Fiscal illusion occurs when voters do not know how much revenue local government obtains from higher government grants. This causes voters to perceive that local services cost less than they actually do, leading voters to suppor greater local spending than they might otherwise. This, coupled with the effects of unfunded state mandates, which passes on the costs of state policies to local governments, has led to a steady increase in New Jersey’s property taxes—the earliest and strongest sign of the state’s unsustainable fiscal path.
 See Charles Tiebout, “A Pure Theory of Local Government Expenditure,” The Journal of Political Economy 64, no. 5 (1956): 416-424.
 See Barry Weingast, “The Economic Role of Political Institutions: Market-Preserving Federalism and Economic Development,” Journal of Law, Economics and Organization 11, no. 1 (1995): 1-31.
 As James Madison, writing in Federalist Paper No. 51, explained: “But what is government itself, but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself. A dependence on the people is, no doubt, the primary control on the government; but experience has taught mankind the necessity of auxiliary precautions.” Alexander Hamilton, James Madison and John Jay, The Federalist Papers, Benjamin Fletcher Wright, ed. (New York: MetroBooks, 2001), 356.
 Grants-in-aid change the division of responsibility within the federal system. Through grants the federal government may nationalize what would otherwise be state activities. Thus, “Grants involve a revision of the Constitution but without formal amendment.” See Richard Wagner, Public Finance: Revenues and Expenditures in a Democratic Society (Boston: Little, Brown and Company, 1983), 466.
 Lars P. Feld and Christoph A. Schaltegger, “Voters as a Hard Budget Constraint: On the Determination of Intergovernmental Grants,” Public Choice 123 (2005): 148.
 Ibid. See also chapter 10 in James Buchanan, Public Finance in Democratic Process: Fiscal Institutions and Individual Choice, in Collected Works of James Buchanan, vol. 4 (Indianapolis: Liberty Fund, 2001).
 See Edward K. Hamilton, “On Non-constitutional Management of a Constitutional Problem,” Daedalus 107 (1978): 111-28. “…we do not know what disciplinary forces can resist impulses to excessive spending when the spender bears no responsibility for raising the revenue being allocated.”
 With increased federal money comes increased federal control of state policy. In theory, states are free to refuse federal money. However, this presents a “prisoner’s dilemma” problem for state government. A state may reject a federal grant and choose to set its own policies; however, that state’s taxpayers will continue to pay federal taxes to finance the grant program for the rest of the states.
 U.S. Government Accountability Office, “Federal Grants” GAO/AIMD-97-7,1.
 Charles Levine and Paul Posner, “The Centralizing Effects of Austerity on the Intergovernmental System,” Political Science Quarterly 96, no. 1 (1981): 68.
 Matching payments from the federal government depend on the amount the state spends on eligible services, and the Federal Medical Assistance Percentage (FMAP) – based on the average per capita income in the state. In FY 2009, the FMAP ranged from 83.62 percent in Mississippi to 56.2 percent in Wyoming. By law the FMAP cannot be lower than 50 percent. See The Henry J. Kaiser Family Foundation, “Kaiser State Health Facts,” http://www.statehealthfacts.org/comparetable.jsp?typ=2&ind=184&cat=4&sub=47&sortc=6&o=a.
 These include inpatient and outpatient services, physician services, medical and surgical dental services, nursing facilities for those 21 and older, home health care for nursing facility patients, family planning services and supplies, rural health clinic services or individual ambulatory services offered by a rural health clinic, laboratory and x-ray services, pediatric and family nurse services, federally qualified health-center services and other ambulatory services, nurse-midwife services, early and periodic screening, and diagnosis and treatment for persons under 21.
 New Jersey also provides the following optional services: treatment in residential treatment centers, optometry services and eyeglasses, dental care, prescription medicines, chiropractic services, psychologist services, prosthetics and orthotics, podiatry services, prescription medicine necessary during long-term care, durable medical equipment, hearing aid services, transportation, personal care services, licensed practitioner services, private duty nurse, services in a clinic, physical therapy, occupational speech therapy, inpatient psychiatric care for individuals between the ages of 21 to 65, and intermediate care facilities for the mentally retarded.
 Carol S. Weissert, “Medicaid in the 1990s: Trends, Innovations, and the Future of the PAC-Man of State Budgets,” Publius 22 (1992): 101.
 Michael Sparer, Sherry Glied and Megan Vanneman, “Medicaid in New Jersey: Options for Reform,” (white paper, Hall Institute of Public Policy New Jersey, 2006).
 Ibid., 4.
 Ibid., 5.
 Ibid., 6.
 These included distributing Medicaid/SCHIP applications to all school children eligible for school lunches.
 The risk of participation in a continually expanded program became clear to states during this period of Medicaid expansion, leading some governors to express concern in 1990 that Medicaid was becoming a “backdoor effort to enact a national health insurance program using the states’ credit card as the financing mechanism.” See National Governors’ Association Bulletin 24, December 7, 1990, 3.
 Weissert, “Medicaid in the 1990s” (1992).
 Joseph Seneca and Richard Hughes, Where Have All the Dollars Gone? (New Brunswick: Rutgers Regional Report, Edward Bloustein School of Planning and Public Policy at Rutgers University, Issue Paper No. 26, October 2007), http://policy.rutgers.edu/news/reports/RRR/RRR_October_2007.pdf.
 New Jersey was the first colony to have no unincorporated land. By 1693, the land was divided into East Jersey and West Jersey, each consisting of 12 townships. Between the Revolutionary War and the early 19th century, most municipalities were formed around the construction and payment for toll roads. See Alan Karcher, New Jersey’s Multiple Municipal Madness (New Brunswick, New Jersey and London: Rutgers University Press, 1998), 54.
 See Robert H. Nelson, Zoning and Property Rights (Cambridge: MIT Press, 1977).
 Alan Karcher notes the most prevalent factors in the creation of many municipal governments were disputes over road jurisdiction, control over schools, the creation of commuter towns around railroads or factories, and alcohol licensing. See New Jersey’s Multiple Municipal Madness.
 Michael A. Egenton, “Modern Forms of Municipal Government,” State Commission on County and Municipal Government (Trenton, NJ, 1992), 2, http://www.njstatelib.org/NJ_Information/Digital_Collections/DIGIDOX1.php
 John P. Snyder, The Story of New Jersey’s Civil Boundaries 1606-1968, (Trenton: New Jersey Department of Environmental Protection, 1969), 23.
 The U.S. Supreme Court ruling in Euclid v. Ambler Realty Co., 272 U.S. 365 (1926), permitted government, rather than private interests, to regulate land use in a community via zoning ordinances. See Karcher, New Jersey’s Multiple Municipal Madness.
 In 1997 the township of Pahaquarry, with a population of less than twelve people, was dissolved and incorporated into neighboring Hardwick Township, bringing the total number of municipalities in New Jersey to 566.
 Karcher, 196.
 Ibid., 195.
 Ibid., 196.
 The precedent for the state controlling local revenues occurred in 1884 with the Railroad Tax Act and the enactment of levies on railroads and railroad property. These levies were determined by a state, rather than a local, Board of Assessors, thereby inserting the state into the local property tax assessment process. Cities with Class II Railroad property shared these locally-collected revenues with the state. This concept of revenue-sharing between the local and state government was extended in 1938 to public utilities in order to help municipalities navigate potential bankruptcy. The Franchise and Gross Receipts Tax collected by the state government on public utilities was distributed to localities according to a formula as an additional source of municipal revenue on top of other locally collected and administered taxes. The state retained a portion of the tax, known as “the state skim,” a practice often criticized by municipalities who viewed the revenue as belonging to local government. See “A Short and Simple Glimpse at the Property Tax in New Jersey,” http://www.njslom.org/tax_brochure.html.
 When the state assumed collection for the Business Personal Property Tax in 1970, it promised to return all of the revenues to the localities. When it assumed collection of the Financial Business Tax, which had formerly been divided between the host municipality and the host county, the levy was doubled, with the new distribution set at 50 percent for the State and 25 percent for the host county and 25 percent for the municipality. These were bundled into the Public Utility and Gross Receipts and Franchise Taxes. In 1982, the state “skimmed” $32 million from the fund for state programs.
 To receive Extraordinary Aid, the municipality must demonstrate that it has taken meaningful steps to resolve budgetary shortfalls, such as improving tax collection, management efficiencies, privatization of services, or sharing services. See http://www.state.nj.us/dca/lgs/lfns/02lfns/mc-2002-2.pdf.
 Author’s calculation. Data taken from New Jersey Division of Local Government Services.
 See http://www.njslom.org/tax_reform_04-2003.html.
 Senate Republican Leader Leonard Lance and Assemblyman Richard Merkt, Minority Statement, Dissent from the Report of the Joint Legislative Committee on Constitutional Reform and Citizens Property Tax Constitutional Convention, 87.
 See http://www.njslom.com/Hardyston-Twp-Mandates-Analysis.pdf.
 Geoffrey K. Turnbull, “The Overspending and Flypaper Effects of Fiscal Illusion: Theory and Empirical Evidence,” Journal of Urban Economics 44 (1998): 1-26.