ABSTRACT
This chapter aims to provide the theoretical and working relationship between federal aid and the tax levels of subordinate governments. It provides the basis for predicting the effects of both reducing the funding level of fiscal federalism and shifting from categorical to block grants. The issue of the interdependence of federal aid and state and local taxes undergirds the theory of fiscal federalism in a "compound republic" and of current presidential policy. Conventional public finance discussions of fiscal federalism are concerned with how federal grants can best be used to overcome externalities in the production of state and local goods and services. Categorical grants, by definition, are quite restrictive, leaving state and local officials little leeway in determining how federal funds are spent. The reductions in state and local tax collections may be offset by greater federal tax collections brought about by the federal government's need to finance the growing Medicaid.
