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States facing a fiscal cliff of their own
The fiscal cliff showdown taking place on Capitol Hill has lawmakers on both sides of the aisle scrambling. However, one important constituency has been all but ignored in this debate -- state and local governments – and could ultimately wind up feeling some of the greatest effects of the fiscal cliff.
The tax changes that are scheduled to occur on January 1, 2013, include both good and bad news for state tax revenue. On the good news front, a study by The Pew Center on the States reveals that for “at least 25 states and the District of Columbia, lower federal deductions would mean more income being taxed at the state level, resulting in higher state tax revenues.” In addition, some states would see revenue increases from scheduled changes in the estate tax or because of federal credits that will be reduced or eliminated.
The sequestration spending cuts carry decidedly worse news for states in terms of their effects on state budgets. State budgets are still struggling from the Great Recession of 2008, and now could see additional cuts. According to the Pew study, federal grants to states comprise nearly one-third of state revenues. Reductions in federal spending because of the fiscal cliff would directly affect federal allocations to states, which would have a direct effect on the strength of states’ economies. Spending cuts could also indirectly affect state revenue by depressing economic activity, which would decrease income and sales tax revenue. States with large military installations could fare even worse because of additional cuts in defense spending.
A side effect of the federal fiscal cliff may be on states’ credit ratings. On December 3, Fitch Ratings released a special outlook warning that the fiscal cliff “is the most significant risk to U.S. states in 2013.” While Fitch is still predicting slow economic and revenue growth for states in 2013, the fiscal cliff “is a significant near-term threat to that forecast.”
While the effect of the fiscal cliff would, in a vacuum, be worrisome for states, the situation is more urgent as states are still recovering from the 2008 recession and many have preexisting structural issues that are not easily remedied. Specifically, many states must begin addressing long-term fiscal challenges that have been put on the back burner. These challenges include how to adequately fund important programs, such as state and local government pensions and health care plans.
These programs are underfunded from years of being short-changed and from the impact of the recession, which caused state trust funds to severely decline in value. In 2009, state pension plans were underfunded by approximately $660 billion. State health care programs and other benefits were underfunded by an additional $607 billion.
The combination of the federal fiscal cliff and state’s long-term fiscal challenges means that states must plan for the future. This is not a can that can be kicked down the road. Given the tight budgets since the recession, the potential for a decrease in federal funding as a result of the fiscal cliff, a possible elimination of the deduction for state and local taxes, and the fact that most states must balance their budget each year, states do not have the ability to put off planning for the future.
No
matter who emerges the winner in the fiscal cliff showdown between
House Republicans and the administration, states cannot afford to wait
for the outcome. Beltway insiders may not be ready for real tax reform,
but for those who manage state budgets, the clock has run out. The
time is now to address the changes ahead and use this opportunity to
bring about lasting reform.
Griffith is a legal editor for State Tax Notes, a publication of Tax Analysts. She will be an expert panel member for Tax Analysts’ upcoming December 14 panel on State Fiscal Cliffs.
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