Chapter 2 of the Education Consolidation and Improvement Act (ECIA) provides small amounts of relatively unrestricted federal funds to state and local agencies on a noncompetitive, formulaic basis; thus it has been hailed as the harbinger of the "new Federalism." The lack of narrow constraints and the simplified application and monitoring procedures distinguish the new Federalism from the old. A conceptual framework is provided for evaluating the effects of Chapter 2, and these concepts are then used to interpret some of its effects in Texas. The first section, "Principles of Fiscal Federalism," addresses the structure, evolution, and justification of intergovernmental transfers. Federal categorical grants have been justified on the grounds of efficiency (spillover of benefits across jurisdictions) and equity (correcting the imbalance between needs and capacities). A theoretical analysis of the effects of categorical grants follows, illustrating how the necessity for constraints is proportional to the divergence between the objectives of national and local policymakers. The second section, "Insights from Consumption Theory," assesses spending patterns as they relate to the hidden costs of categorical programs (negotiation, monitoring, and reporting) and concludes that the shift to formula-based grants will most likely increase participation. The effects of Chapter 2 in Texas are then cited to confirm these hypotheses. (TE)