Reihan Salam cogently argues federalism is on the wrong path due to powerful incentives tied to federal funding. Long story short, federal dollars create the impression for state governments that program expansions are "free," passing the blame for spending from the state to the federal level. Salam proposes an incremental approach to reversing this trend (forgive the lengthy quote):
Because getting from here to there in one single bound would be very difficult, we could go for an incremental approach. First, Congress would federalize the part of Medicaid that is responsible for meeting the needs of low-income seniors who also qualify for Medicare, a group that accounts for 15 percent of Medicaid enrollees but 39 percent of total Medicaid spending.
States would continue to operate the under-65 part of the program, but instead of receiving today’s open-ended funding commitment, they would receive federal block grants that are tied to a state’s poverty level and whether or not the state’s economy is in recession. Granted, this would still be federal money with strings attached, at least at first, but there would be less money and fewer strings. Reforming Medicaid along these lines would help create a sane and sensible division of labor between the states and the federal government.
We could go much further to encourage real competition among state governments. Recently, for example, Rohit Aggarwalla of Bloomberg Philanthropies called for abolishing the federal surface transportation program and the federal gasoline tax that funds it, leaving state governments to fund highways as they see fit.
This approach would allow states to experiment with new approaches to funding transportation, including following the lead of governments in Australia and New Zealand by turning state Departments of Transportation into regulated, self-financing public corporations.
The beauty of Aggarwalla’s approach is that it would force state governments to put up or shut up. Low-tax states would either starve their highway systems of much-needed investment or they’d demonstrate their superior efficiency. High-tax states, meanwhile, would either see huge economic gains from lavishly funded roads and bridges, or they’d waste vast sums on expensive boondoggles. We’d have a fighting chance of seeing which approaches to transportation work and which do not.
In an ideal world, we’d extend this logic to K-12 education as well. The federal government would get out of the K-12 business, apart from requiring state governments to report data about the quality of schools and funding basic research. Everything else would be left up to state governments, which would spend more time pursuing innovative approaches and less time chasing federal dollars.
Another way for enterprising federalists to encourage states to wean themselves from the federal governmnent's teat? Work to end the state and local tax deduction, which acts as another form of welfare for high tax locales. Get rid of that deduction, and angry taxpayers in New York, Illinois and California will further push their leaders to demand fiscal sanity.