Beyond the Cliff: The Rough Road Ahead for States in 2013

Despite all of the drama over the past few weeks, it looks like both sides are ready to split the difference.  The President began the negotiations by calling for $1.6 trillion in tax revenue, Speaker Boehner countered with $800 billion.  A deal would likely include roughly $1.2 trillion, the midpoint between both first offers.  The president began by stating that any deal must spare social safety net programs and offering only $400 billion in ill-defined cuts while Speaker Boehner said that entitlement reform and other spending cuts must form the majority of any deal.  Both sides are now hinting at a compromise including equal amounts of revenue and spending cuts.  

If the promising developments of the past few days prove illusory and the country is pitched into a $682 billion chasm, the short-term impact on state budgets will be manageable.  Sequestration would strip roughly $4 billion in non-defense grant funding from the states, but most of these grants are for specific programs, such as low income energy assistance (LIHEAP) and economic development programs, which would be missed by their recipients but would not fundamentally challenge state general fund balances.  In addition, should the Bush-era tax cuts expire many states would see a modest increases in short-term tax revenues as most states link their systems to federal deduction levels.

The true threat from the cliff lies in its impact on the real economy rather than on the intergovernmental fiscal relationship.  Although the debate has broken down along partisan lines, the economic impact pays no attention to the red and blue divide. 

While Democrats have emphasized the need for revenue, should all of the expiring tax measures go into effect blue states may stand to lose the most.  A recent estimate from Moody’s Analytics estimated that the Northeast alone could face a 2% or greater increase in unemployment driven in part by the disproportionate impact of the Alternative Minimum Tax (AMT) and other tax increases on the region.  Similarly while Republicans have led the charge to limit the impact of defense cuts, three of the top five states that stand to suffer the most from defense reductions in per capita terms are solidly red state Connecticut, Hawaii, and Maryland (see chart below).

However, for state budgets a crisis averting deal could offer as much peril as the cliff itself.   Once the debate shifts the immediate cuts and tax increases to revenue and entitlement reform, state tax deductions and Medicaid will be placed squarely in the cross hairs.   Despite all the talk about tax increases for the wealthy, both the President and Speaker Boehner are counting on reducing tax deductions to bring in the lion’s share of the new revenue that will be included in any deal. 

There are only two ways to accomplish this goal, by reducing or eliminating deductions for specific “tax expenditures” or by setting a cap on the total amount of deductions individuals can take.  Either course will likely produce substantial limitations on the ability of citizens to deduct state income, property, and sales taxes from their federal taxes as well as limiting the tax exemption for municipal bond interest. 

Neither the President nor the Speaker have provided a detailed list of deductions they would target, but if given a choice between curtailing mortgage interest, health care, or charitable deductions or going after states you can guess how the debate will play out.  In fact, the $800 billion in new revenue through undefined deduction reforms that Boehner included in his initial offer lines up strikingly close to the ten year savings that would be achieved by removing the state tax deduction alone.  Even if both sides choose to reform taxes by setting a cap on deductions, perhaps $25,000 or $40,000, mortgage interest alone could quickly consume the deduction cap for many tax payers precluding many from deducting state taxes.  Once citizens see that their state tax bill can no longer be counted on to deliver a federal refund, their frustration will inevitably play out in state capitals.

While details surrounding potential spending cuts have been as sparse as on the revenue side there are a few areas where both sides agree, including the need to dramatically curtail the ability of state to use special provider taxes to fund their Medicaid programs.  Reducing these measures, where states tax hospitals and other Medicaid providers and use the revenue to draw down as much as three to one in federal matching funds, could save the federal government as much as $60 billion over ten years in reduced Medicaid spending.  Provider tax restrictions are but one element of a long list of potential reductions in Medicaid funding that could cost states $100 billion over ten years.   

Since the birth of the New Deal almost 80 years ago the state-federal relationship has been dominated by debates over spending.  However, with state tax deductions, bond interest exemptions, and Medicaid provider taxes all under fire, the story for 2013 and perhaps many years to come will be about revenue.  

The coming debate may offer some new opportunities for states.  Leaders on both sides of the aisle have provided strong assurances that the Marketplace Fairness Act, a measure designed to give states the authority to compel online venders to collect sales taxes, will pass early next year.  However, the actions congress takes to address the federal fiscal crisis and rationalize the tax code could easily constrain the ability of states to manage their own revenue streams for decades to come.