Budget Cuts, Revenue Swings Await States In ‘Fiscal Cliff' Drama

If President Obama and congressional leaders fail to avert the so-called “fiscal cliff” currently looming in Washington, the slate of actions scheduled to take effect January 1, 2013 would slash federal spending, trigger one of the largest federal tax hikes ever and could plunge the economy back into recession.

And state budgets and economies would be hit particularly hard by the automatic tax increases and spending cuts, according to the report released Thursday (November 15) by the Pew Center on the States' Fiscal Federalism Initiative, which explores how the fiscal cliff would affect states in a number of ways. (Stateline is also a project of Pew Center on the States.)

All told, the fiscal cliff would raise federal taxes $393 billion in the current federal fiscal year, while reducing spending by $98 billion. Education and safety-net funding would be targeted, and reductions in the federal workforce could cost hundreds of thousands of jobs. Federal tax changes could mean drastic swings in state revenues, potentially unsettling budgets still recovering from a recession-driven drop in revenues and deep deficits.

The spending cuts, which have received a great deal of the attention in the fiscal-cliff debate, would slash defense and non-defense discretionary spending by a total of about $100 billion each year over the next decade. That means core programs like Medicaid, Medicare and Social Security would be spared from the budget axe, while other programs would face blunt across-the-board reductions.

As Stateline previously reported, the reductions would mean a 10 percent cut in discretionary defense spending, while non-defense discretionary defense spending would be cut about 7.5 percent. For states, the defense cuts would have a significant, if indirect, effect. Virginia, for example, could see economic activity fall by more than $10 billion and lose almost more than 120,000 jobs as a result.

But the non-defense cuts would have a direct effect on dollars states rely on to fund countless programs, from education to energy assistance grants for low-income households. Basic federal education funding would be cut by $1.3 billion and special education would be cut $1 billion, along with myriad other programs subject to the automatic cuts.

The effects could vary wildly from state to state, as the Pew report details, but the reductions are likely to be felt one way or another, with some faring far worse than others.

For example, the report says federal grants that would be cut make up more than 10 percent of South Dakota's total revenue, and comprise 8.5 percent of revenue in Illinois and Georgia. More specifically, the education cuts could be particularly harmful depending on the state. In 2010, almost 5 percent of South Dakota's state revenue came from federal education programs, while the same funds accounted for just 2 percent of Delaware's revenue, according to the report.

The effect of the cuts also would depend how much a state relies on federal dollars as a share of its economic activity. For instance, Maryland, Virginia and Washington, D.C. attribute nearly one-fifth of their economic output to federal spending, according to the report, and Hawaii for nearly 16 percent. But in New York, Minnesota and Delaware, federal spending makes up 2 percent or less of economic activity.

Changes in federal taxes as a result of the fiscal cliff, though, could mean significant swings in revenue for nearly every state, although the exact impact would also vary. There are 37 states, for example, that link personal income taxes to federal personal income tax provisions that would expire. Another 33 states link estate taxes to expiring federal estate tax provisions, and 23 link corporate income taxes to expiring provisions of federal corporate income taxes, the report says.

What that means is more than two dozen states could see revenues increase as a result of changes to federal deductions and credits as a result of the fiscal cliff, although analysts and the report warn the economic damage resulting from the fiscal cliff could wipe out those gains. The report also says six states would see revenues fall because they allow taxpayers to deduct federal taxes – which would increase – from their state taxes.

Louisiana, in particular, illustrates the impact of these tax links. The state allows taxpayers to deduct what they pay in federal taxes from their state taxes, which means the amount paid would decline as a result of increased federal rates. But at the same time, the ending of certain federal deductions and credits for both personal and corporate income taxes (along with an increase in the estate tax) would mean more revenue for the state.

On the other hand, Arizona's personal income tax is tied to only certain federal deductions that would expire. That change would mean slightly more revenue for the state, but many of the rest of federal tax changes wouldn't have a direct effect on collections.

The exact effect the fiscal cliff debate will have on the states, though, depends in large part on whether, or to what degree, the policies end up taking effect. As the Pew report details, there's not only uncertainty about how the fiscal cliff will ultimately be resolved, but also about how the complex policy changes will interact with each other and the broader economy.

What's more, it's possible the White House and Congress could delay the entire plan before year's end, or they could strike a deal to avert some or the entire fiscal cliff while cutting the deficit at the same time. Any such changes — except a wholesale delay — also would have an effect on states, leaving policymakers facing a particularly fluid situation as they prepare for new budget sessions in most states to begin in 2013.