On the afternoon of January 27, a memo from the Office of Management and Budget (OMB) went out stating that there would be a temporary pause on grant, loan, and other financial assistance programs at the OMB effective 5 PM Eastern time the next day. As quickly as the memo went out, it was rescinded. The Department of Government Efficiency (DOGE), however, appears undeterred and continues to uncover waste at various federal agencies. Now, states must be prepared to receive less taxpayer money from the federal government and live within their means.

　　The national outrage at the mere mention of the federal government ending transfers proves the accuracy of the French political economist Frederic Bastiat’s definition of the state: “the great fictitious entity by which everyone seeks to live at the expense of everyone else.” Federal financial assistance is simply taxpayer dollars being transferred from net payers to net recipients. These transfers also provide the federal government with a means of control: people who receive these transfer payments will change their behavior to ensure that the money keeps coming.

　　This episode should be a wake-up call for America: End the co-dependent relationship caused by federal transfers. Policymakers at all levels of government must be prepared to rein in spending. Net recipients of these transfers must be prepared to live without support from the federal taxpayers. Making the conscious decision to end the relationship now will be far less painful than if it must be forcibly severed when the federal government faces a fiscal crisis.

　　Of course, the warning signs should have been clear to Americans long ago. The relationship between the federal government and recipients of federal transfers was clearly outlined by Philip Hamburger in his book Purchasing Submission. In the book, he discussed the “transactional mode of control,” the ways the federal government uses bureaucracy to push through unconstitutional policies by promising government assistance. The assistance comes with terms and conditions that recipients must accept. “The Constitution,” he wrote, “is a law publicly enacted by the people. It therefore cannot be altered or excused by the consent of states or private persons.”

　　In an interview for The Law Liberty Podcast, Hamburger elaborated, “It’s not just the threat to rights. There’s a purchase of consent to a whole new mode of governance, an alternative mode of control. And so when you step back and see that, conditions are no longer a technical problem, that’s actually a profound question of political theory and law.”

　　Unfortunately, the recipients of federal transfers are more than happy to make this exchange. In an explainer I recently wrote for the American Institute for Economic Research, I argue that in many cases a combination of social services pays more than the median income in all 50 states and Washington, DC. These welfare programs mostly provide “in-kind” benefits—meaning benefits that are given from the government to a provider without any funds going to the recipients of the welfare. Economist Michael Tanner comments that this “infantilizes the poor” because “in most cases, the payments are made directly to providers. The person being helped never even sees the money.” In most cases, recipients lose the ability to choose what options are available to them and must take what the government provides. For example, under Medicaid the government pays healthcare providers that accept Medicaid coverage. Medicaid recipients do not see any of the money.

　　At the state level, expenditures funded by federal transfers make up 34 percent of the average state’s total spending. In Fiscal Years 2021 (July 1, 2020-June 30, 2021 for most states) and 2022 (July 1, 2021-June 30, 2022 for most states), federal transfers made up the largest source of state expenditures thanks to the massive federal pandemic expenditures. Most of these federal transfers (on average 56 percent) are spent on Medicaid. As data on state expenditures show, the average state pays less of its own tax revenue toward Medicaid now than before the enactment of the Affordable Care Act (ACA). States also use accounting gimmicks, such as healthcare provider taxes, to artificially inflate Medicaid spending and maximize the federal matching rate. States tax healthcare providers, the tax revenue collected is used to match federal funds so that the state gets additional federal Medicaid dollars. Economist Brian Blase finds that many healthcare providers are happy to pay provider taxes, knowing it will generate net profits through increased federal transfers. State governments and healthcare providers game the system so federal taxpayers, most of whom are unaware of how Medicaid funding works, end up footing the bill. To make matters worse, a new study from Brian Blase and Rachel Greszler estimates that the number of improper Medicaid payments (payments that should not have been made or that were made in the incorrect amount) are more than double what Medicaid reported because Medicaid did not include eligibility checks (the number of Americans who received Medicaid but did not qualify for it) into their payment error audit.

　　State policymakers can either choose to make spending cuts now on their own terms or scramble to fill budget gaps when DC surprises them with cutting transfers.

　　Individuals and state governments will happily accept terms and conditions in exchange for someone else financing their desired spending. The federal government is happy to dole out the funds and achieve policy goals they could not have through the normal legislative process. In the end, federal taxpayers pay the bill.

　　But what will happen when DC turns off the spigot? Total public debt exceeds $36 trillion and continues to rapidly climb. The federal government has ended every fiscal year in a budget deficit since 2001. In FY 2024, for every dollar the federal government spent:

　　53.4 cents went to entitlements, 12.82 cents went to net interest payments on the public debt, 12.68 cents went to national defense, and 18.23 cents went to all other federal programs. Net interest payments on the public debt are steadily increasing, especially in the wake of US Treasury note credit downgrades.

　　As my colleague Peter Earle mentioned last year when the total public debt was only $34 trillion, “Too much credibility has been squandered on the futile endeavor of predicting fiscal tipping points.” A better approach would be to explain the consequences of life after the federal government is unable to continue spending at current levels.

　　Federal policymakers will decrease federal transfers to the states before they dare touch direct transfers to individuals, lest federal policymakers incur the wrath of voters. As I previously discussed, states will be left scrambling to cover funding shortfalls when DC cuts transfers to state governments. When these budget shortfalls are combined with billions of dollars of state debt, many states will face budget crises.

　　I have previously compared the state of Illinois to Greece just before the Eurozone debt crisis. Large amounts of debt, corruption, and poor management in the Land of Lincoln bear painful reminders of Greece in the wake of the Great Recession. Judging by their actions during the COVID-19 pandemic, the first thing policymakers in Springfield are likely to do when faced with a fiscal crisis is to turn to DC (and federal taxpayers) for a bailout.

　　Time is rapidly running out for Illinois to get its fiscal house in order. While I will not try to hammer down a “fiscal doomsday” date for the Land of Lincoln, I implore readers to watch the state closely. Even if you live in a different state, the federal government can still use your hard-earned money to bail out Springfield’s poor financial decisions.

　　The first thing Congress and DOGE must do to prepare Americans for adjustments is credibly commit to not bailing out the states. This could be in the form of a law banning federal funds from bailouts or a constitutional amendment. A more controversial approach could be adding a chapter of the US Bankruptcy Code for state governments. As Ryan Yonk and I discuss in Understanding Public Debt, bankruptcy is not a “quick fix” for state fiscal woes, but it could be preferable to a federal bailout or a state attempting to not pay its debts by declaring sovereign immunity.

　　The burden, however, does not rest solely on DC policymakers. State policymakers must prepare for the inevitable cuts. This can be achieved through spending restraints, such as the Taxpayer’s Bill of Rights (TABOR) Amendment in Colorado, and can serve as a guide for states looking for strong constitutional constraints on taxes and spending. States can also require state agencies to have an emergency plan in place in case of a 5-25 percent cut in funding (simulating a cut in federal funds). These strategies have worked in part for Utah as part of its “Financial Ready Utah” plan, enacted in the wake of the Great Recession. State governments can also preemptively require state agencies to seek legislative approval before applying to federal programs to ensure that agencies do not “double dip” and receive funding from the same federal agency.

　　As net interest payments on the national debt rapidly crowd out other spending, politicians in DC will have no choice but to follow DOGE recommendations for spending cuts. State policymakers can either choose to make spending cuts now on their own terms or scramble to fill budget gaps when DC surprises them with cutting transfers. The OMB memo and the ensuing panic is a preview of the latter situation.