The Impact of the Fiscal Cliff on the States

Nov 15, 2012

Update: Fiscal Cliff Deal Poses Uncertainty For States

The state impact of the fiscal cliff’s expiring federal tax provisions and scheduled spending cuts is missing from the national discussion. This study finds that the effects on the states vary greatly based on the extent to which states are tied to the federal tax code and federal spending.

The fiscal cliff looms large in current fiscal policy debates. Discussions about the effect of the tax increases and spending cuts included in the fiscal cliff have focused on the national budget and economy. But federal and state finances are closely intertwined, and federal tax increases and spending cuts will have consequences for states’ budgets.

For example, almost all states have tax codes linked to the federal code.

  • For at least 25 states and the District of Columbia, lower federal deductions would mean more income being taxed at the state level, resulting in higher state tax revenues.
  • At least 30 states and the District of Columbia would see revenue increases because they have tax credits based on federal credits that would be reduced.
  • At least 23 states have adopted federal rules for certain deductions related to business expenses. The scheduled expiration of these provisions would mean higher taxable corporate income and hence higher state tax revenues in the near term.
  • Thirty-three states would collect more revenue as a result of scheduled changes in the estate tax.

However, six states allow taxpayers to deduct their federal income taxes on their state tax returns. For these states, higher federal taxes would mean a higher state tax deduction, reducing state tax revenues.

The scheduled spending cuts also would have a significant impact on states. Federal grants to the states constitute about one-third of total state revenues, and federal spending affects states’ economic activity and thus their amount of tax revenues.

  • Roughly 18 percent of federal grant dollars flowing to the states would be subject to the fiscal year 2013 across-the-board cuts under the sequester, according to the Federal Funds Information for States, including funding for education programs, nutrition for low-income women and children, public housing, and other programs.
  • Because states differ in the type and amount of federal grants they receive, their exposure to the grant cuts would vary. In all, the federal grants subject to sequester make up more than 10 percent of South Dakota’s revenue, compared with less than 5 percent of Delaware’s revenue.
  • Federal spending on defense accounts for more than 3.5 percent of the total gross domestic product (GDP) of the states, but there is wide variation across the states. Federal defense spending makes up almost 15 percent of Hawaii’s GDP, compared with just 1 percent of state GDP in Oregon.

The public interest is best served by an enriched policy debate that incorporates implications for all levels of government and leads to long-term fiscal stability for the nation as a whole.

Note that the general economic slowdown that could result if the full fiscal cliff were allowed to take effect would likely overwhelm any of the separate components discussed here.

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