The State-Federal Forecast: Storm Clouds Arriving in the Fall
When Congress returns from its summer holiday, it will have just nine legislative days to stave off the next fiscal crisis. This next chapter in the cliff-driven saga that has roiled Washington since the passage of the Budget Control Act two years ago, however, likely will put state revenue systems squarely in the crosshairs of Congress.
The dual deadlines that form the contours of the next cliff are driven by the failures of Congress both to agree on a funding level for the federal government for the next year and to reach a long-term compromise on the deficit. The House and the Senate are considering appropriations bills with discretionary spending levels that are more than $100 billion apart, leaving little hope that anything can be passed before the Sept. 30 deadline. At the same time, Congress will need to raise the debt ceiling within the next few months or risk default.
Republicans are unlikely to sign on to either a continuing resolution to prevent a government shutdown or a debt ceiling increase unless they get something in return. Sen. Ted Cruz of Texas has led a chorus of conservatives calling for defunding the Affordable Care Act as a quid pro quo for both votes. Such a deal, however, would be dead on arrival at the White House. A more likely scenario is for conservatives to reluctantly sign on in return for an expedited vote on comprehensive tax reform.
Tax reform has been one of the sleeper issues of the year. While both the House and Senate have held hearings on reform, neither chamber has come close to offering a bill. In fact, the debate over what exemptions might be eliminated or reduced has been so furtive that the Senate Finance Committee has taken the unusual step of sealing the public submissions it has received to date for 50 years.
The issue that bedevils reformers is that while simplifying the tax code sounds good, the list of tax expenditures—exemptions that reduce federal revenues by over $1 trillion each year—reads like an inventory of political interests. The biggest numbers on the list come from employer contributions for health care, mortgage interest and 401K contributions—all areas that are untouchable in the current climate.
The only category that generates enough savings to make a meaningful difference for rate reduction is the $105 billion in state-related tax expenditures stemming from the $69 billion impact of state income and sales tax exemptions and the $36 billion impact of exclusions for interest income on municipal bonds.
Both President Obama and House Republicans have indicated they would be willing to cap or eliminate the tax preference for municipal bonds, and a host of commentators have noted that the state income tax exemption largely benefits high earners. If Congress were to cap exemptions at the 28 percent level as the president suggested, it would drive up bond yields and add more than $170 billion to state borrowing costs over the next 10 years, while the elimination of the exemption would drive up state costs by more than $500 billion. Similarly, eliminating the state income and sales tax deduction would place severe pressure on states to reduce their tax rates.
The only silver lining to be found in such a scenario is that the House would be much more likely to back the stalled Marketplace Fairness Act, which the senate passed earlier this year with 69 votes and would allow states and localities to collect up to $23 billion in sales tax from online sellers, if it is folded into a reform package that also targets state-related tax benefits.
A win on Marketplace Fairness, however, would be a pyrrhic victory if gained in exchange for massive increases in bond yields and new pressures on state revenue systems. The risk to states in the months ahead may be far greater than the sequestration cuts and other measures that states have had to absorb so far as they have traveled the cliff-strewn path of a bitterly divided Congress.