Without a Cliff Deal, States Will Bleed Red Ink
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The Fiscal Times
November 16, 2012

While Washington is transfixed by the drama over the looming fiscal cliff, state officials across the country are bracing for the possibility of damaging economic ripple effects if President Obama and congressional leaders can’t negotiate a deal to block a huge rise in federal taxes and automatic spending cuts set to kick in by early January.

Many state officials had been counting on another good year of revenue growth and improving economic conditions after years of budget shortfalls throughout the Great Recession. But with parts of the East Coast devastated by Hurricane Sandy and the possibility of a year-end federal fiscal calamity, governors and state officials across the country are on high alert.

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According to a new study by the Pew Center on the States released on Thursday, the general economic slowdown that would result from an estimated $600 billion of tax increases and spending cuts taking hold next Jan. 2 would significantly affect state economic activity and indirectly undercut many state budgets.

Because federal and state finances are so closely intertwined, the tsunami of expiring Bush era tax cuts and the sequester of defense and domestic spending program would hit the states in a multitude of ways, rendering most of them either winners or losers depending on the extent of their dependence on federal aids, grants and defense contracting, and the details of their state income tax laws.

"The fiscal cliff looms large in current fiscal policy debates,” said Anne Stauffer, project director of the Fiscal Federalism Initiative at the Pew Charitable Trust. “Discussions about the effect of the tax increases and spending cuts included in the fiscal cliff have focused on the national budget and economy. But federal and state finances are closely intertwined, and federal tax increases and spending cuts will have consequences for states’ budgets."

For example, six states that allow residents to deduct federal taxes from their income in filing state tax returns – Alabama, Iowa, Louisiana, Montana, Missouri and Oregon – would lose substantial state revenue if all the Bush-era federal tax cuts are allowed to expire by the end of the year. That’s because the more those residents are charged in federal taxes the less they have to pay in state income taxes.

Conversely, for the 43 states and the District of Columbia that levy a personal income tax, most of them would see an increase in revenues in the coming year if Obama and Congress allow the tax cuts and other deductions to expire. That’s because those states link their tax systems to the federal revenue code by adopting various federal definitions of income or various federal deductions and credits.

If the tax cuts are allowed to expire, that would mean – for example – the reinstatement of limits on some deductions for high-income taxpayers (estimated to increase 2013 federal revenues by $6.1 billion) and the elimination of the deduction for higher education tuition and fees (nearly $1 billion).Depending on how a state’s tax code is written, lower federal deductions could automatically result in more income being taxed at the state level as well, which would increase state revenue.

Moreover, at least 23 states have adopted federal rules for certain deductions related to business expenses. The scheduled expiration of those provisions would mean higher taxable corporate income and hence higher state tax revenues. And scores of states would see their revenues rise with the elimination of other federal tax breaks and credits.

The bad news is that the more than $100 billion of automatic across-the-board cuts in defense and domestic spending set to take effect beginning in January (the dreaded sequester) would deliver a serious blow to many states that have grown accustomed to substantial federal aid and procurement. This is particularly true in states such as Maryland, Virginia, New Mexico, Kentucky and Hawaii that are home to substantial defense industry facilities and military installations and that benefit from much higher than average national spending.

Federal spending on defense accounts for more than 3.5 percent of the total gross domestic product of the states, but there is wide variation across the states. Officials at Lockheed-Martin and other major defense contractors have warned of as many as one million layoffs in the defense industry if the country goes over the fiscal cliff.

Other states including South Dakota, Illinois, Georgia and Texas that are more heavily dependent than most states on federal grants would also be most susceptible to the threatened sequester if there is no deal.

The fiscal year that began Oct. 1 marks the third consecutive year that state officials have forecasted growth in state tax revenues compared with the previous year. Despite this positive trend, the robust resurgence of state tax collections that marked previous economic recoveries remains elusive. According to the Nelson A. Rockefeller Institute of Government, following five quarters of declines brought on by the Great Recession, total state tax collections rose for 10 consecutive quarters since the first quarter of 2010. Growth, however, has slowed in the last four quarters.

But some states, including New Jersey and New York, are struggling with the destructive aftermath of Hurricane Sandy, and will feel enormous pressure on their budgets as the states work toward a recovery, while Californians just approved a major tax hike to pay for public schools and close a huge hole in the state budget.

New Jersey Gov. Chris Christie said this week that property owners in areas devastated by Sandy may face higher tax bills, as local governments exceed his two-percent cap on annual increases to cover rebuilding costs. He said municipalities will be able to get federal aid to cover some rebuilding costs, and said the property-tax increase cap he and lawmakers passed in 2010 has a natural-disaster exemption.

“It tells taxpayers in towns that were destroyed that they’re probably going to have higher taxes -- it’s got to be paid for,” Christie said. “Most people in these towns will recognize that if they believe the money is being spent reasonably and responsibly to rebuild their towns, they’ll be happy to do it.”

Beyond the strain of the super storm recovery, officials at Pew warn that that the generally upbeat projections for state revenues across the country could all change if the country goes over the cliff and back into recession. Increased unemployment, lower disposable income, and lower spending would mean both lower income and sales tax revenues and an increase in the number of individuals who would qualify for state safety net programs such as Medicaid and unemployment insurance.

“The federal changes to tax policies will affect all states but it all really depends on the structure of each state’s economy," said Stauffer of the Pew center. “Virginia is the only state we’ve heard of that has a contingency plan in place, but I know that most states are likely preparing plans as well."

Washington Editor and D.C. Bureau Chief Eric Pianin is a veteran journalist who has covered the federal government, congressional budget and tax issues, and national politics. He spent over 25 years at The Washington Post.