Tax Analysts Blog

Despite Revenue Growth, States Must Plan for the Fiscal Cliff

Posted on Dec 12, 2012

The Rockefeller Institute recently released a state revenue report for the second quarter of 2012. The report indicates that although overall state tax revenues increased by 3.2 percent from the same quarter last year, total state tax revenues in the second quarter of 2012 are still 2 percent lower than the peak levels that were reported in 2008 before the economy crashed.

This sounds like mixed news, but what does the report really mean? It is positive that the second quarter of 2012 was the tenth consecutive quarter that states reported growth in tax collections, but states still haven’t reached 2008 levels of tax revenue. So while states are recovering from the recession, the report indicates they are not out of the woods; in fact, they are far from it.

Now, the U.S. is poised on the edge of the so-called “fiscal cliff,” and states are fearful of what will happen if the U.S. teeters off. Several analysts have predicted that the combination of tax increases and spending cuts that will kick in if Congress cannot come to a compromise by the end of the year will send a still fragile U.S. economy back into recession.

Despite the current stalemate in negotiations, most analysts still predict that Congress will come to a compromise and prevent the U.S. from completely fall off the cliff. But let’s assume for a moment that no comprise is reached and the U.S. free falls off the fiscal cliff. What effect would that have on states? (Tax Analysts is having a conference on this topic on December 14.)

Let’s look first at the effect of the potential tax increases on states. The tax changes that are scheduled to occur on January 1, 2013, include an expiration of the 2001, 2003, and 2009 tax cuts. The expiration of these cuts affect tax rates imposed on ordinary income and capital gains, corporate income, and estates. The temporary “patch” of the alternative minimum tax (AMT) would expire, as would the payroll tax cut.

There are also a variety of tax extenders that would expire. These include such things as a research and experimentation tax credit and enhanced deductions for certain business expenses. Finally, the new taxes imposed by the Affordable Care Act would kick in. These tax changes would generate $393 billion in revenue in 2013.

While these tax changes would undoubtedly affect state tax revenue, it is not all bad news for states. Some of the changes would actually increase state revenue. For example, according to a study conducted by The Pew Center on the States, for at least 25 states and the District of Columbia, lowering federal deductions would result in more income being taxed at the state level. More income being taxed means higher state tax revenues.

In addition, some states would see revenue increases because they have credits based on federal credits being reduced or eliminated or because they conform to the federal tax code for the business deductions set to expire. The elimination of a credit or other deduction also results in more revenue subject to tax. Finally, the study reports that 33 states would see a revenue increase because of the scheduled changes in the estate tax.

Still, there are other provisions that would reduce state tax revenue. For example, at least 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 a lower state tax liability.

Next, let’s look at the effect of the potential spending cuts on states. The spending cuts carry decidedly worse news for states in terms of the effects on state budgets. Unless a compromise is reached, the required cuts include the sequestration under the Budget Control Act of 2011, the expiration of federal unemployment insurance benefits, and the expiration of the Medicare “doc fix.” Taken together, the spending cuts will generate $98 billion.

Federal grants to states comprise a large chunk of state revenue. While there is variation among states, estimates are that federal grants are approximately one-third of state revenues. Reductions in federal spending directly affect the federal allocations provided to states, which in turn has a direct effect on the strength of states’ economies and the amount of tax revenue they are about to collect.

The Pew study also suggests the spending cuts will have an indirect effect on state revenue by depressing economic activity, particularly in states where more federal spending occurs. Also, cuts in defense spending would hurt those states with large military installations, and reductions in personal spending would reduce sales tax revenue.

There is little question that reductions in federal spending would have an impact on states; the question is how large will the impact be. The Federal Funds Information for States (FFIS) predicts that states will see a $7.5 billion funding reduction for programs subject to sequester. However, according to FFIS, states receive 82 percent of their federal funding via grants are exempt from sequestration. The largest federal grants, including Medicaid, are included in those grants that are exempt.

In addition to the federal fiscal cliff, states may be facing fiscal cliffs of their own. The combination of the scheduled spending cuts, the slow recovery from the 2008 recession, an increased demand for public services, and concern over the underfunding of state and local government pensions and health care programs has led some analysts to suggest that regardless of a compromise on the federal fiscal cliff, states may be forced to face their own destiny.

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 (even if for programs that are not directly related to state pensions or healthcare), and the fact that most states must balance their budgets each year, states do not have the ability to stick their collective heads in the sand. Despite the economic troubles of the past and the fiscal uncertainties of the present, state lawmakers must focus on the future.

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