State Budgets and the New Congress

The 113th Congress was sworn in today and the new freshman class found their seats still warm from predecessors who worked well into the New Year to pass a cliff averting tax compromise.   While the drama over the fiscal cliff may have passed for the moment, the new Congress faces another set of crisis-laden deadlines that could have big implications for state budgets.

The cliff compromise, known officially as the American Tax Payer Relief Act of 2012, has offered state budgets a temporary reprieve.    Had the full measure of tax increases and spending cuts gone into force the economic impact for states would have been far more dramatic than any reductions in federal grant payments.   The tax changes alone could have added 2% or more to the unemployment rate in some states, particularly in the Northeast and Upper Midwest where the impact of the tax increases in (largely the Alternative Minimum Tax or AMT) would have been most severe.

The deal may also provide a small bump for state general fund revenues.  Income taxes are levied by 41 states plus the District of Columbia and most rely on the federal adjusted gross income determination to calculate state tax returns.  The increase in the top end bracket (from 35% to 39.6%), the capital gains rate (from 15% to 20%), and estate taxes (from 35% to 40%) plus the phase out of tax deductions for individuals making over $250,000 will increase income determinations for tax filers and generate modest increases in state tax revenues for most states. 

However, with both a debt ceiling vote and a new sequestration deadline looming by the end of February, Medicaid, the linchpin of the state-federal fiscal relationship, is now squarely in the crosshairs for cuts.  Between the Budget Control Act of 2011 and the recent cliff deal, Congress has reduced America’s long term deficit projections by $1.6 trillion – a far cry from the $4 trillion in deficit reduction hoped for from a Simpson-Bowles style grand bargain.  The modest savings that have been achieved have come solely through discretionary spending cuts and tax increases.  As a result, any new compromise to increase the debt ceiling or reduce sequestration cuts will require substantial changes to entitlement programs.  States can anticipate loosing at least $100 billion in Medicaid funding over ten years in any new deal, with much of the cost savings achieved by restricting the provider taxes states have increasingly used to fund their programs. 

While the acrimony surrounding the tax compromise will make it hard to forge a consensus for comprehensive tax reform in the short term, both the administration and Congress recognize that reforming the tax code is essential for catalyzing the country’s still anemic economy recovery.  There is particular interest in reducing the corporate tax rate, which is among the highest in the industrialized world, by limiting the deductions and credits known collectively as “tax expenditures”.   However, any tax reform effort will likely restrict 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. 

States were holding out hope that the Market Place Fairness Act, a bill designed to provide states with the authority to compel online sellers to collect state sales taxes, would be enacted by the outgoing Congress.  While this proved to be a bridge too far, leaders on both sides of the aisle have indicated that it will likely pass early in the new Congress.  This legislation could generate over $20 billion a year for states.  The downside is that the passage of the bill will now likely be folded into the tax reform debate and may be granted in exchange for the exact type of state tax deduction limitations that states are eager to avoid.

States have a two-month window to ensure their voices are heard as Congress considers entitlement and tax reforms that will echo out in state budgets for a decade to come.  There will be no unified voice from states given the partisan dimensions of these issues, but some ideas, such as granting states more authority to run their Medicaid programs should Congress scale back funding for the program, have wide bipartisan support in the state community.   The challenge will be to ensure that state concerns are heard amid the cacophony of a Congress that looks to be as crisis-driven as the one it just replaced.