paper on fiscal federalism at Mercatus.
The consequences of the federal government's pervasive funding of state governments are simple: "Instead of competing for residents, states are competing for central government funding and privileges. Such activity breeds wasteful spending and rent-seeking, which are drains on the welfare of American society." California is a perfect example of this problem. The state can bestow lavish public benefits on its citizens and then send the bill to citizens of other states via Washington D.C. In this sense, California is competing for citizens not by prudent fiscal policy, but by costly state giveaways to targeted groups. Our federal system of government should not support such behavior.
For more, Cato has a section on fiscal federalism in its most recent "Handbook for Policymakers."