It’s no surprise that the fiscal relations between the federal government and the states are tangled. We saw that last year in the tax reform battle over the federal deductibility of state taxes. And we see it in the constant battles over federal aid for state activities such as education and health care. Liberals dream of making the federal-state relationship one of “cooperative federalism.” They envision Uncle Sam’s deep pockets and superior expertise helping the states deliver well-designed and efficient programs.
That vision is naïve. In reality, today’s federal-state interactions are more like “corrupting federalism” in that they undermine sound governance. The federal deduction for state taxes — now scaled back — has induced states to overtax. And federal funding of state activities induces state and local governments to spend wastefully because the money comes “free” from Washington.
Federal aid also promotes outright fraud, something made very clear to me when researching the low-income-housing tax credit (LIHTC) with my Cato Institute colleague Vanessa Brown Calder. The federal LIHTC distributes $9 billion a year in tax credits to state and local governments, which in turn hand them out to selected developers to build affordable housing. But the federal government performs little oversight as the states play with tax breaks that don’t cost them anything. The Internal Revenue Service provides the LIHTC benefits to the states, but its oversight “has been minimal,” say federal auditors. The assistant U.S. attorney investigating the Miami fraud said, “It’s really a program of trust,” meaning the deals are rarely subject to detailed review.
This lack of oversight has made projects tied to the tax credit rife with fraud. In 2016, for example, Miami developers pled guilty to stealing $36 million from 14 LIHTC housing projects by inflating construction costs to maximize the tax credits. Similar LIHTC scams have been busted around the country from Oklahoma to California.
Worse than fraud, the LIHTC also generates government corruption in jurisdictions across the country. That is because state and local officials hand out the valuable credits to housing developers of their choosing. Housing developers in California vying for the tax credits have flooded state politicians with campaign contributions in recent years. These donations do not go unrewarded. State treasurer John Chiang, for example, has helped steer millions of dollars in housing tax credits to developers that have donated more than $100,000 to his 2018 campaign for governor.
Perhaps the key player in California’s LIHTC corruption has been Advanced Development and Investment Inc., a builder of 50 affordable-housing projects in the state. The company’s leaders were indicted for fraud in 2016. The Los Angeles Times found that subcontractors to ADI “provided more than $400,000 in campaign contributions to politicians across the state, including at least $165,000 in Los Angeles. Four subcontractors told the Times they felt pressured to donate by ADI.
In Glendale’s 2009 City Council election, the newspaper reported: “Nearly one of every four dollars received by the top four candidates — more than $100,000 — came from ADI subcontractors, those subcontractors’ employees and the employees’ relatives. . . . Glendale provided ADI more than $33 million to help build four affordable-housing projects. Officials there believe roughly half that amount was lost because of fraud.”
In Dallas, the LIHTC was at the center of the public corruption case in 2010, the largest in the city’s history. It is a complex story, but the core corruption involved the mayor pro tem (a senior city councilor) and the planning commissioner shaking down developers for bribes in return for approving housing tax credits and zoning changes. The Dallas LIHTC program “required city council approval of all projects . . . [and so] the guy with a good friend at City Hall would have a huge advantage,” reported the Dallas Observer. In the end, 14 people were convicted of bribery, extortion, and related crimes, including developers, a state representative, the mayor pro tem, and the planning commissioner.
The LIHTC recipe for corruption—federal subsidies, little federal oversight, and discretionary state-local business hand-outs — is replicated in other federal programs. The Department of Housing and Urban Development, for example, provides $11 billion a year in “community development” money to state and local governments, which dish it out to favored local groups and businesses. The program has long been plagued by waste, fraud, and corruption.
The solution to these problems is clear: If states want to waste money subsidizing local groups and businesses, they should fund it themselves. Federal aid compounds waste because state-local policymakers are not frugal with federal cash and federal policymakers are too distracted to worry about local abuse.
With soaring federal deficits, Congress will feel pressure to slash fiscal aid to the states in coming years. That is good news, because federal cuts would restrict a fuel source that is fanning the flames of corruption in state and local governments.