States facing a fiscal cliff of their own

Still, there are other provisions that would reduce state tax revenue. For example, the Pew study reports six states permit taxpayers to deduct federal income taxes on their state tax returns. If taxpayers are paying more in federal income tax, the corresponding result on the state side is a higher state tax deduction, which would mean lower state tax liabilities. That is unless the state and local tax deduction is eliminated as part of an overall fiscal cliff compromise.

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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