Are We at a Tipping Point in Inter-State Subsidies?

Indiana gets far more spending from the Federal Government than we pay in taxes each year. This is because we are an increasingly poor state, with a lower Federal tax burden and a higher share of transfer payments. This makes the debate over what Trump calls the “Big Beautiful Bill” of long-term consequence to Hoosiers.

There are plenty of short-term problems with this bill. There’s no need for me to detail them all – the global bond market is doing a fine job of that. But, one issue that one that merits close attention is how the current budget debate might change the nature of Fiscal Federalism in the United States.

Over the past century, the United States has built a tax and spending system with three features that lead to very distinct geographic differences in tax collections and spending.

First, we have a modestly progressive federal taxes that lay a heavier burden of tax revenue on more affluent people. Adam Smith described it thusly; “the rich should contribute to the public expense, not only in proportion to their revenue, but something more than in that proportion.”

Second, we have a transfer system in several parts. One type handles old age and disability – our Social Security and Medicare system. Another offers short term medical, food and financial help to the poor – Medicaid, SNAP and TANF. Others pay veteran benefits, subsidize agriculture and offer other transfers of wealth from current taxpayers to recipients.

Third, we involve states in many of these programs, with taxpayers in more affluent states paying a higher share of the total cost of programs than those in poor states.

The effect of this is sort of a triple whammy to rich states, who pay a higher share of Federal spending on programs, while also having to pony up more in state tax dollars for their share of these programs, despite spending more to alleviate poverty in their states. Not surprisingly, many of these affluent states are tiring of this arrangement.

One partial remedy to this is the expansion of State and Local Tax Deductions (SALT), that allow taxpayers to deduct their state and local taxes from their Federal tax bill. An expansion of SALT deductions is contained in the “Big Beautiful Bill” despite widespread GOP opposition.

Keep in mind, over the past couple decades, shifting demographics along with rapidly changing policy positions mean that the GOP now overwhelmingly represents poor places, while Democrats represent affluent places. That means the ‘equilibrium’ that maintained a pattern of rich people and rich people transferring money to poor people and poor places is in jeopardy.

One way to see how large this difference is lies in comparing Indiana to Illinois. Our neighbors to the west earn 16% more per year in income, so are much more affluent than us. Here in Indiana, we pay $5,371 per resident in state taxes and $9,615 per resident in Federal taxes. In comparison, Illinois residents pay $7,321 per resident in state taxes and $14,122 per resident in Federal taxes.

The progressive taxation really clobbers Illinois compared to Indiana. But, the flow of Federal dollars back to each state is even more remarkable. As of 2022, Hoosier residents get back $3,333 more from the Federal government than they pay in taxes each year, while Illinois residents get $1,313 less per year than they pay in taxes. All this excludes the COVID payments which makes Indiana look worse.

The Medicaid system is a great synopsis of this problem.

Illinois collects 36% more per person in state taxes than does Indiana. They waste some of this, but they also do much better at reducing poverty. But they really shine in doing things that promote prosperity. Educational attainment in Illinois absolutely crushes that of Indiana. The share of their adults with college degrees is almost 10% higher, which is the causal force behind much higher incomes in Illinois.

Even with the disparity in state, local and Federal taxes, take home pay in Illinois is higher than that of Indiana.

But, the Medicaid rules also ask rich states to pay a higher level of their state taxes on Medicaid than they do poor states. The average Hoosier pays $651 per year to support the state’s Medicaid program, while Illinois residents pay $920 per resident. What must be particularly galling to Illinois residents is that they have a substantially smaller share of their population receiving Medicaid.

So, this is the triple whammy. Illinois collects more in state and local taxes, and in so doing, reduces its poverty levels, Medicaid dependency and does a far better job educating residents than does Indiana. In turn, this means Illinois residents pay a higher share of their earnings into Federal taxes to subsidize poor states that do less to pull themselves up by their bootstraps.

In return, Illinois has to spend more state money on their smaller share of residents on Medicaid, while Federal tax dollars more heavily subsidize Indiana, who then turns around and spends less of their state tax revenues on Medicaid.

This sort of arrangement was politically possible 20 years ago, when Republican and Democrats represented rich and poor states pretty evenly. That’s no longer the case. So, the debate about SALT deductions is just the first taste of what is likely to be an embittered and difficult policy environment for our current tax and subsidy system.

I welcome that debate. Citizens of every state would be better off from simply having a clear, fact-based discussion about the level and type of taxes and subsidies that flow from place to place. Like most in the GOP, I’d prefer zero SALT deductions. The federal tax system should let states make their own taxing decisions without interference. But, using exactly the same rationale, I don’t think Illinois should be subsidizing Indiana’s Medicaid spending.

Just to be clear, Indiana would be the clear financial losers under this principled tax position. But what we lose in tax dollars, we gain in honest self-reflection.