Populism, Federalism, and the American System

Once central to the movement, regional identities have taken a backseat to other culture war identities.

by Joshua McCabe

This article first appeared on The American Conservative, May 11, 2023

This series begins by asking what new ideas we can discover by looking at Henry Clay’s old idea of the American System, arguing for more robust state action to rebuild our industrial base, restore national infrastructure, and protect workers and consumers. Historically and today, much of the focus has been on national development in the context of international competition.

But this focus risks obfuscating the impact of the American System on regional development. Critics of Clay in the South and Midwest, for example, complained that the American System benefited the northeast to the detriment of their own regional development. The rise of Southern and Midwestern populists can be seen as a response to the excesses of the American System during the late nineteenth century.

The new American System takes the plight of struggling regions more seriously but still needs to consider how national policies continue to favor development in prosperous regions (with the West Coast now joining the Northeast) at the cost of struggling regions. With our agrarian past behind us, where can a new populist movement find guidance for these new problems? A particularly trenchant criticism comes from an unlikely source: economist and Nobel Laureate James M. Buchanan who recognized that economic development policy cannot be divorced from issues of federalism and public finance.

Buchanan is most famous for influencing a generation of conservative economists on the growth of Leviathan, the seductive power of deficits, and the benefits of constitutional constraints. This view neglects Buchanan’s pathbreaking work on fiscal federalism and the problem of regional fairness. Rediscovering the value of this work can provide us with new insights into how to craft a truly national economic system that leaves no regions behind.

The rapid industrialization that swept the United States between 1880 and 1929 created a new level of prosperity for the average American. Rapid developments in transportation and communication allowed us to push new boundaries in the division of labor and specialization, leading to what was once unimaginable growth in productivity.

The uneven distribution of resources—capital, labor, and natural resources—across the states meant that there was a spatial component to specialization as well. Regional specialization created new gains in productivity but also created new inequalities across states as capital-intensive industries increasingly clustered in the Northeast, leaving the South behind. The Great Depression brought these inequalities into stark contrast.

The Roosevelt administration sounded the alarm in 1938 with the release of the Report on the Economic Conditions of the South. Calling the South “the Nation’s No. 1 economic problem,” the report detailed the region’s economic struggles. The South had a wealth of natural resources but enjoyed relatively few of their benefits because it lacked the capital to develop and purchase them. Incomes for “prosperous” Southern farmers were only a third of what farmers made elsewhere. The wealthiest Southern state had a lower per capita income than the poorest non-Southern state.

The report identified several impediments holding back the South, including states’ limited ability to raise enough revenue to fund basic government services. Lower land values in the South relative to the Northeast meant the latter states “had three times as much property per person to support their schools and other institutions.” Income taxes did not provide better options as:

so much of the profit from Southern industries goes to outside financiers, in the form of dividends and interest, that State income taxes would produce a meager yield in comparison with similar levies elsewhere. State taxation does not reach dividends which flow to corporation stockholders and management in other States; and, as a result, these people do not pay their share of the cost of Southern schools and other institutions.

These crucial points, all but forgotten in Washington today, would become central to Buchanan’s thinking on fiscal federalism.

Buchanan was born and raised in a small town in Tennessee. He later described his “origins in the rural agricultural poverty of the upper South.” Though his work is often described as highly abstract or theoretical, new work from Alain Marciano makes clear that Buchanan’s experiences growing up in the South profoundly impacted his fiscal federalism research.

Growing up in Middle Tennessee—one of the historical centers of agrarian populism—was particularly important in shaping Buchanan’s choice of topics later in his academic life. His grandfather, John P. Buchanan, rode the wave of populism sweeping the region into one term as governor. As part of the short-lived Farmers’ Alliance Party, his grandfather railed against the dominance of the “eastern establishment”, which many felt was controlling the region’s destiny from afar with little concern for those trying to make a living in the area.

This populist tradition was passed down in the family. Buchanan himself grew up reading radical populist pamphlets. One of the recurring themes he would have encountered was the idea of regional fairness. Whether it was regulating railroad rates, establishing a federal income tax, or  reducing  tariffs, populists saw policy battles as matters of regional fairness pitting the South and West against the East.

Buchanan recalled listening to Cordell Hull speak about free trade during a local visit and “sensed that the free trade principle was indeed central to the traditional democratic-Southern-populist set of values” and that “this principle had been subverted throughout much of the nation’s history by the protectionist-monopolist interests of the East and North.”

Viewed in this context, Buchanan’s early work as a graduate student at the University of Chicago makes perfect sense. Seemingly dry term paper titles such as “Federalism: One Barrier to Labor Mobility” or “A Theory of Financial Balance in a Federal State” addressed the set of problems like the populists of the preceding century and Roosevelt’s report on the South.

These strands of Buchanan’s thought came together with the 1950 publication of his seminal paper on federalism and fiscal equity. In it, he explores how to address the fiscal inequities that can arise when federal and state governments both have the power to tax and spend. This was a particularly important issue in the United States for two reasons.

First, national economic development was an uneven process that led to the concentration of higher financial returns in some regions but not others. Governments’ ability to raise revenue depends on available fiscal capacity, or taxable resources. The highly industrialized states of the North had much greater fiscal capacity than the agricultural states of the South. By 1950, New York’s per capita income (a common measure of fiscal capacity) was still more than twice that of Mississippi.

Second, the growth of new spending responsibilities across all levels of government during the Progressive and New Deal eras required unprecedented levels of taxation to pay for public services. The 1930s and 1940s saw a flurry of new income, sales, and excise tax adoptions as state and local governments scrambled to fund newfound responsibilities.

An issue arose, according to Buchanan, when states of unequal fiscal capacity were expected to produce similar levels of public services, such as transportation and education, that are fundamental to economic growth and the general public welfare. How could a state like Mississippi provide public services on par with a state like New York if the former had a fraction of the fiscal capacity to do so? Buchanan spelled out the suboptimal choice facing states in struggling regions: They could raise taxes much higher than other states to fund similar levels of public services or provide paltry levels of public services to keep taxes at reasonable levels.

This situation had the potential to create significant market distortions. In a healthy market economy, labor and capital tend to be allocated most efficiently where returns are highest. Southern states’ inability to combine low taxes and functional public services would incentivize the migration of workers and capital to states that could provide both. Even if Mississippi and New York had the same economic policies, the former would be at a disadvantage because of its much more limited fiscal capacity. Absent any federal support, struggling regions would be stuck at a competitive disadvantage, hindering their economic development.

Buchanan acknowledged this efficiency problem, but what really interested him was the equity problem it presented for the United States. Asking states to provide similar levels of public services despite disparities in fiscal capacity violated the principle of equal fiscal treatment for equals. Fiscal justice required that “persons earning the same income and possessing the same amount of property will no longer be subjected to a much greater fiscal pressure in Mississippi than in New York, solely because of residence in Mississippi.” Southerners were effectively penalized for living in a struggling region while Northerners were subsidized for living in a thriving region.

The solution, according to Buchanan, was relatively simple. The federal government could provide a block grant to states with below-average fiscal capacity that would enable them to provide an average level of public services at average tax rates. Buchanan was clear these equalization block grants should have no strings attached because states’ limited fiscal capacity resulted “through no fault of their own or of their respective citizens” and therefore the federal government had no right to tell them how to spend funds that were “ethically due” to them. Ethics aside, it was also clear to Buchanan that “low income states provide deficient educational standards largely because of their fiscal plight; remove this, and it seems likely that their service standards would approach those of other states without any restraints upon state budgetary freedom.”

One would be hard-pressed to find a better blend of populism and economic thinking than the concept of the equalization block grant. It achieves traditional economic goals—efficiency and equity—via populist means: redistribution from the wealthy states of the North to the struggling states of the South. It was a potent case that helped introduce equalization block grants in Australia and Canada. And yet Buchanan’s America remains the only federalist country without one. 

The reason would be unsurprising to Buchanan as a Tennessee populist and public choice economist: the Eastern establishment had little to gain from introducing a federal grant that would only go to struggling states, so they oscillated between indifference and opposition to efforts to address the problem. Efforts to introduce fiscal equalization were largely limited to a small set of categorical matching grants created during the New Deal. Initially, federal grants for state social assistance programs (Aid to the Blind, Old Age Assistance, and Aid to Dependent Children) required states to match them with their own funding. The flat matching rate formula favored states with more fiscal capacity that could afford to take advantage of it.

Sensing a standalone equalization was a nonstarter, Southern states pushed for a shift to variable rate matching formulas that would provide more federal support for states with less fiscal capacity. It took three decades and the accumulation of institutional power in the hands of a member of Congress from Arkansas to win a major battle. But struggling regions continue to lose the war as our meager system of federal grants still does little for the states that can least afford it. Such fiscal equities are ripe for a new populist backlash, if channeled correctly.

Drawing on history, the proponents of the new American System have pointed to a number of policy prescriptions, ranging from industrial policy to Opportunity Zones, to uplift struggling regions as part of broader national economic development goals. The new populists, on the other hand, have so far offered no agenda for struggling regions. Once central to the movement, regional identities have taken a backseat to other culture war identities. Buchanan’s work on fiscal equity and the case for an equalization block grant could start that agenda for any entrepreneurial leader looking to revive this dormant movement into a national powerhouse again.

This article is part of the American System series edited by David A. Cowan and supported by the Common Good Economics Grant Program. The contents of this publication are solely the responsibility of the authors.

Joshua McCabe is the director of social policy at the Niskanen Center. His work focuses on the fiscal foundations of family economic security.