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December 17, 2012
Are States Facing Their Own Fiscal Cliffs?

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by Cara Griffith

Cara GriffithThe state and local tax world has been strangely quiet in the days since the election regarding one very important topic: the fiscal cliff. Although a sense of concern seems to be growing among state and local tax officials, there has been surprisingly little discussion on the effect of the fiscal cliff on states. Yet state and local governments should be taking a front row seat during discussions of how to address the fiscal cliff because it may directly affect them. This article addresses the potential effects of the federal fiscal cliff on states and considers whether states are facing fiscal cliffs of their own.1


States and the Federal Fiscal Cliff

The federal fiscal cliff is, of course, the scheduled tax increases and spending cuts that are set to occur on January 1, 2013. Unless a compromise is reached in Congress, the fiscal cliff could have a significant effect on the U.S. economy. Most analysts are predicting that the combination of tax increases and spending cuts would send the U.S. economy, still fragile from the Great Recession of 2008, back into recession.

Although negotiations for a compromise are still underway, let's assume for a moment that no compromise is reached and the United States free falls off the fiscal cliff. What effect does that have on states? The answer, unsurprisingly, is complex. Let's look first at the effect of the potential tax increases on states.

The tax changes that are scheduled to occur on January 1, 2013, include an expiration of the 2001, 2003, and 2009 tax cuts. The expiration of those cuts affects tax rates imposed on ordinary income and capital gains, and also affects the corporate income tax and the estate tax. The alternative minimum tax would remain unpatched for the 2012 season, and the payroll tax cut would expire. A variety of tax extenders also would expire. Those include a research and experimentation tax credit and enhanced deductions for some business expenses. Finally, the new taxes imposed by the Affordable Care Act would kick in. Those tax changes would generate $393 billion in revenue in 2013.

Although those tax changes could affect state tax revenue, the news for the states is not all bad. Some changes could increase state revenue. For example, a study conducted by the Pew Center on the States reveals that 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."2 Also, there would be revenue increases in some states because they have credits based on federal credits being reduced or eliminated or because they conform to the federal tax code for the business deductions set to expire. Finally, the study reports that 33 states would see a revenue increase because of the scheduled changes in the estate tax.

However, other provisions would reduce state tax revenue. For example, the Pew study reports that six states permit taxpayers to deduct federal income taxes on their state tax returns. If taxpayers are paying more in federal income tax, the corresponding result on the state side is a higher state tax deduction, which would mean lower state tax liabilities.

Next, let's look at the effect of the potential spending cuts on states. The spending cuts carry decidedly worse news for state budgets. Unless a compromise is reached, the required cuts include the sequestration under the Budget Control Act of 2011, the expiration of federal unemployment insurance benefits, and the expiration of the Medicare "doc fix." Taken together, the spending cuts would amount to $98 billion.3

According to the Pew study, federal grants to states constitute nearly one-third of state revenue. Reductions in federal spending directly affect the federal grants provided to states. That in turn has a direct effect on the strength of states' economies and an indirect effect on the amount of tax revenue they are able to collect. The Pew study suggests the spending cuts will indirectly affect state revenue by depressing economic activity, particularly in states where more federal spending occurs. Also, cuts in defense spending would hurt states with large military installations, and reductions in personal spending would reduce sales tax revenue.

There is little question that reductions in federal spending would have an impact on states -- the question is the size of the impact. The Federal Funds Information for States predicts that states will see a $7.5 billion funding reduction for programs subject to sequester. However, according to the Federal Funds Information for States, states receive 82 percent of their federal funding via grants that are exempt from sequestration. The largest federal grants, including Medicaid, are included in those exempt.


State Credit Ratings

Another potential effect of the federal fiscal cliff may be on states' credit ratings. On December 3 Fitch Ratings released a special outlook warning that the fiscal cliff "is the most significant risk to U.S. states in 2013."4

"While Fitch expects continued slow economic and revenue growth for 2013, the Fiscal Cliff is a significant near-term threat to that forecast. The risk that the Fiscal Cliff presents to the overall economy is the biggest concern for state credit, as state revenue systems quickly reflect changing economic conditions," said Laura Porter, managing director at Fitch, in a statement.

The Fitch statement cautions that cuts in federal spending will likely lower state funding, forcing states to cut programs or fund some programs with other sources of revenue. "Decisions that shift the cost of services from the federal to state governments, while requiring the states to provide the same level of services, would be most concerning," the report said.


State and Local Tax Deductions

Although fiscal cliff negotiations in Congress are ongoing, there has been some discussion of eliminating or reducing benefits from some income tax deductions, at least for higher-income taxpayers. Of the deductions that could be on the chopping block, the deduction for state and local taxes may be the most likely to gain any political traction. The deduction for mortgage interest and the charitable deduction seem safe at the moment.

The deduction for state and local taxes is available to taxpayers who itemize their deductions. Taxpayers are permitted to deduct most state and local taxes paid during the tax year.5 In testimony before the U.S. Senate Finance Committee, Frank Sammartino, Congressional Budget Office assistant director for tax analysis, reported that just under one-third of all tax filers claimed the deduction.6 And, as expected, the amount of state and local taxes paid increases as taxpayers' income increases. Only 25 percent of tax filers with income under $100,000 claimed the deduction, while over 85 percent of tax filers with income over $100,000 claimed it.

State and local governments are protective of that deduction because it provides them an indirect federal subsidy. In essence, because taxpayers are allowed to deduct state and local taxes, the actual cost of the state and local taxes is reduced. The tax policy behind limiting the state and local tax deduction is that those taxes are paid to the state or local government in return for services. If government services are thought of as another form of personal consumption, they should not be treated as a deductible expense. That means that state and local governments can impose higher taxes than they otherwise would be able to impose.

The Joint Committee on Taxation estimated that the tax subsidy provided to state and local governments through that deduction was $67 billion in 2011.7 States that benefit the most from it are high-income, high-tax states (such as California, New Jersey, and New York).


State Fiscal Cliffs

Although the federal fiscal cliff will have decided consequences for states, most of the debate in the mainstream media has focused on the potential effect of the federal fiscal cliff on the national economy, not on state economies. Yet state economies are in a precarious position. In addition to the effects of the federal fiscal cliff, states may be facing fiscal cliffs of their own. The combination of the scheduled spending cuts under the federal fiscal cliff, the slow recovery from the 2008 recession, increased demand for public services, and already underfunded state programs has led some analysts to suggest that regardless of what happens with the federal fiscal cliff, states may be forced to face their fates on the edge of their own fiscal cliffs.

The 2008 recession hit state budgets hard. States had to pare down to the point of questioning the provision of even the most basic services and to determine what was truly vital. Millions of employers, including state governments, were forced to lay off workers. But even as tax revenue was falling and state workers were being laid off, the need for public services grew as laid-off workers sought unemployment and Medicaid.

Recovery from the recession has been slow and painful, and is still ongoing. State budgets are, however, showing positive signs. The Nelson A. Rockefeller Institute reported in October 2012 that state tax revenue grew by 3.2 percent in the second quarter of 2012.8 States have now reported growth in tax collections for 10 consecutive quarters. But although the Rockefeller report is positive, it said that total state tax revenue in the second quarter of 2012 is still 2 percent lower than peak levels reported in 2008. And if state tax revenue is adjusted for inflation, it was 7.7 percent lower in the second quarter of 2012 than in the same quarter in 2008, according to the report. Even without a potential reduction in federal funding, 19 states are already projecting shortfalls for their fiscal 2013 budgets.9

All that is evidence that states are still struggling to fully recover from the recession. As noted above, one reason is that despite the recession, the demand for public services has continued to grow. Since 2008 there has been an increased demand for unemployment compensation and Medicaid. But even before the 2008 recession, declines in federal spending and changing population demographics forced states to shift more revenue into public service programs.

States, already working on tight budgets, shifted funds around to meet the increased demand in those programs. When that happens, two of the areas routinely shortchanged are state and local government pension and healthcare plans, which has left those plans underfunded. The underfunding is the result of years of shortchanging the programs, but was made worse when the 2001 and 2008 recessions caused state trust funds to severely decline in value. In 2009 state pension plans were underfunded by approximately $660 billion.10 State healthcare programs and other benefits were underfunded by an additional $607 billion.


State Pensions

Most state and local governments provide some form of retirement income for their employees. Often, governments provide defined benefit plans, in which employees are guaranteed a specific pension payment upon retirement. Defined benefit plans are funded through dedicated trust funds, which are funded to cover future pension liabilities. Payments into those trust funds come from employers (the state or local government) and employees, and the amounts in the funds are invested.

The level of underfunding in state and local government pensions is significant. The report of the State Budget Crisis Task Force (the budget crisis report) indicates that, using actuaries' current assumptions to value liabilities, state and local government pensions are underfunded by approximately $1 trillion.11 However, the picture is even worse if liabilities are valued using "low-risk" discount rates. Under that approach, the report indicates state and local pension plans are estimated to be underfunded by $3 trillion.


Healthcare

In addition to pension benefits, many state and local governments provide healthcare benefits to retired state and local government workers, as well as life insurance and other smaller benefits. Often, those programs receive little funding because they are funded on a pay-as-you-go basis. Those state and local government programs are estimated to have unfunded liabilities of more than $1 trillion.12 The budget crisis report cautions that if the federal government increases the eligibility age for Medicare, liabilities for those programs could increase because state and local government healthcare benefits often provide coverage during the transition period between retirement from government service and eligibility for Medicare.

State Tax Reform

The combination of the federal fiscal cliff and states' long-term fiscal challenges means that states must begin planning for the future. This is not a can that can be kicked down the road. Given the tight budgets since the recession, the potential for a decrease in federal funding (even if for programs that are not directly related to state pensions or healthcare), the existing underfunded programs, and the fact that most states must balance their budget each year (and must stop shifting funds to achieve a balanced budget), states do not have the ability to put off planning for the future. They must plan for more than one year at a time.

Although that is a daunting task, the combination of factors puts states in the position of needing and potentially being capable of real tax reform. But what should tax reform look like? How do state lawmakers plan for the future, given the troubles of the past and the uncertainty of the present?

There is no single answer because the needs of each state and each state's tax system are different. But there are some guiding principles that states should follow when drafting major tax reform. The writings of Donald Bruce, Steven Gold, and Eugene Steuerle, taken together, have explained that tax reform is a change in the tax system designed to improve equity, economic efficiency, and simplicity.13 And in this case, there is another factor on which tax reform must be measured. Any effort at state tax reform must now adequately fund the public services the state will be required to provide.

In economic terms, a state tax system must be designed with revenue sufficiency in mind. A paper by Benjamin Russo, put out by the National Conference of State Legislatures, explains that concept well, saying: "Sufficiency is fundamental because none of the other economic goals of reform is likely to be achieved if the tax system does not provide sufficient revenue to meet state and local funding requirements."14 Without sufficient revenue, a state tax system will inevitably face a financial crisis, whether only once every few decades or every other year. When that financial crisis hits, all efforts of the state turn to balancing the budget and other goals or needs go unfunded. That perpetuates the cycle of insufficiency.

Elizabeth McNichol and Iris J. Lav from the Center on Budget and Policy Priorities provide a strategy for restoring underfunded state pension programs to full fiscal health.15 While acknowledging that states must act now to create a plan for restoring solvency to pension trust funds, McNichol and Lav downplayed the fact that underfunded pension programs are an immediate problem. They believe the "long-term nature of the problem means that most state and local governments can fashion a plan that postpones significant additional pressure on state budgets for a few years until revenues have recovered from the current downturn."

The CBPP report further suggests that states should change pension rules to reduce the potential for abuse, carefully change their methods for determining needed contributions, gradually move to increase contributions to pension funds by governments and employees, and modestly scale back benefits. Finally, it suggests that states continue offering defined benefits plans (rather than switch to pay-as-you-go plans).

The CBPP report recommends that states increase funding of pensions from an average of 3.8 percent of state and local budgets to 5 percent of budgets. And because "of the long time horizon, state and local governments can safely take two or three years to ramp up to the higher contributions," said McNichol and Lav.

But what if in the next two to three years states are feeling the pinch of reduced federal funding? Or even worse, what if in the next two to three years the national economy has slipped back into a recession? Although the CBPP report does suggest "common-sense" solutions, it was written before any discussion of the federal fiscal cliff and therefore does not account for the potential effects of the fiscal cliff, which may cause states to take several additional years to fully recover from the 2008 recession and any additional reductions in federal funding that occur.

When the unfunded liabilities for state and local healthcare plans and other benefits are added in, states face even more potential liabilities. The budget crisis report uses Illinois as an example of what that means for taxpayers. Illinois was recently estimated to have total unfunded liabilities of $203 billion, which translates to more than $15,800 per capita.

States must look ahead to the possibility that economic recovery may take years longer than expected and plan accordingly. To fend off large tax increases (which undoubtedly would not be good for the economy during a period of fiscal crisis), states may have to consider increasing employee contributions to pension plans or decreasing benefits.

The solution is to return to the principles of good tax policy. The Tax Foundation has long promoted those policies, which include simplicity, transparency, neutrality, stability, no retroactivity, a broad base, and low rates.16 The foundation is right on the mark. The budget crisis report suggests that an eroding state tax base is at the core of the problem. But rather than addressing the problem of a narrowing tax base, states have compensated by increasing tax rates.

The sales tax is a good example. In large part because of the advent of Internet shopping, sales tax revenue has declined because more purchases are made online and many online vendors have not been required to collect sales tax for purchases if they do not have a physical presence in the same state as their customer (and customers likewise do not remit use tax on those purchases). To counter that, states increase sales tax rates. It becomes a vicious cycle.

Internet sales taxation is likely to be addressed next year by Congress and will result in more sales being subject to tax. Although there was positive movement on the marketplace fairness bills in Congress this year, given the more pressing questions facing the lame-duck Congress, it is unlikely either of the marketplace fairness bills will move.17 That said, Amazon and other large retailers (with the exception of eBay and Overstock) are no longer vehemently opposing these bills, so it seems likely that a bill will move in the next Congress.

States should, if embarking on fundamental tax reform, seek to reverse the trend of continuously narrowing the tax base and raising rates. Broadening the tax base and lowering tax rates is nearly always a better choice. Also, states should question their reliance on the corporate income tax (if they impose one). For state tax purposes, the corporate income tax is too cyclical to be a stable form of revenue. Because most states are required to balance their budgets, they should opt to rely more heavily on stable streams of revenue.

All that is said with the backdrop that many state tax systems conform at some level to the federal tax system, which means that there are tax consequences from the fiscal cliff that may be out of their control. Because of that, states should constantly address their budgetary outputs, including amounts that are put toward entitlement programs. Underfunding in state and local government pensions and healthcare plans can be addressed by either decreasing the plans' liabilities or increasing the assets in the plans' trust funds.18 If states are unable to increase the amount of assets in the plans, the value of the benefits will have to be decreased. State tax reform will not solve the problem of overspending.


Conclusion

State and local officials must engage federal lawmakers during discussions on the fiscal cliff. They must educate the federal government on the fiscal cliff's effect on states, but state and local officials must also begin to address their other, long-term fiscal challenges. It is difficult to predict what Congress will ultimately do about the fiscal cliff, but states should be exploring how they will manage any potential changes. States simply cannot afford to wait.

* * * * *

Cara Griffith is a legal editor of State Tax Notes.

FOOTNOTES

1 Tax Analysts recently held a conference on that topic. For a transcript of the conference, see http://www.taxanalysts.com.

2 For prior coverage of the study, see State Tax Notes, Nov. 26, 2012, p. 619, Doc 2012-23695 or 2012 STT 223-3. The study, "The Impact of the Fiscal Cliff on the States," is available at http://www.pewstates.org/uploadedFiles/PCS_Assets/2012/Pew_fiscal_cliff_report.pdf.

3 See Pew report, supra note 2.

4 Fitch Ratings, "2013 Outlook: U.S. States," Dec. 3, 2012.

5 For 2011 taxpayers had the option of claiming state and local sales taxes as an itemized deduction instead of claiming state and local income taxes (taxpayers cannot claim both). That option expires on December 31, 2012, unless extended.

6 Frank Sammartino, "Federal Support for State and Local Governments Through the Tax Code," testimony before the U.S. Senate Finance Committee, Apr. 25, 2012, available at http://www.cbo.gov/sites/default/files/cbofiles/attachments/04-25-TaxCodeTestimony.pdf.

7 Joint Committee on Taxation, "Estimates of Federal Tax Expenditures," 2011-2015, JCS-1-12 (Jan. 17, 2012).

8 Lucy Dadayan and Donald J. Boyd, "Sales Tax Revenues Show Slowest Growth in Law Two Years," State Revenue Report, the Rockefeller Institute, Oct. 2012, available at http://www.rockinst.org/pdf/government_finance/state_revenue_report/2012-10-25-SRR_89_v2.pdf.

9 National Governors Association and National Association of State Budget Officers, "The Fiscal Survey of States (Spring 2012)," available at http://www.nasbo.org/sites/default/files/Spring%202012%20Fiscal%20Survey_1.pdf.

10 http://www.pewstates.org/uploadedFiles/PCS_Assets/2011/Pew_pensions_retiree_benefits.pdf.

11 The report is available at http://www.statebudgetcrisis.org/wpcms/wp-content/images/Report-of-the-State-Budget-Crisis-Task-Force-Full.pdf.

12 The report of the State Budget Crisis Task Force estimates state-administered programs are unfunded by approximately $600 billion with the remaining liabilities from locally administered programs.

13 Benjamin Russo, "State Tax Reform: Evidence, Logic, and Lessons From the Trenches," State Tax Notes, Feb. 13, 2006, p. 467, Doc 2006-308 , or 2006 STT 29-3 . Russo noted that "Gold (1999) says 'State tax reform changes the structure of state and local taxes so that revenue is obtained with greater equity, and fewer economic distortions and in sufficient quantity to allow governments to provide services.'" Steuerle (1999) says "reform as improvement, not merely amendment, generally is based upon bringing the law into closer adherence to . . . public finance principles of efficiency, growth, equal treatment of those in equal situations, and simplicity." And Bruce (2001) defines reform as "a significant change in the tax system designed to make it more efficient, more fair or equitable, and less complex." Using those authors as guides, tax reform here will refer to systematic changes in the tax system that improve equity, simplicity in administration and compliance, economic efficiency, short-run stability, and long-run revenue sufficiency.

14 Russo, "State Tax Reform: General Principles and Lessons From Prior Efforts," prepared for the State and Local Finance Modernization Study Commission, available at http://www.ncleg.net/DocumentSites/committees/FiscalModernization/Comission%20Meetings/Nov%2028%20and%2029/Nov%2029%20Presentations/State%20Tax%20Reform%20Lessons%20from%20Prior%20Efforts%20-%20Paper.pdf.

15 Elizabeth McNichol and Iris J. Lav, "A Common-Sense Strategy for Fixing State Pension Problems in Tough Economic Times," CBPP, May 12, 2011, available at http://www.cbpp.org/files/5-12-11sfp.pdf.

16 Explanation of those principles can be found on the Tax Foundation's website at http://taxfoundation.org/article/principles-sound-tax-policy.

17 Although the Marketplace Fairness Act was proposed as an amendment to the National Defense Authorization Act, the Senate voted to close the debate on December 4, 2012, and vote on the act without voting on the amendment.

18 "The Underfunding of State and Local Pension Plans," Congressional Budget Office Economic and Budget Issue Brief, May 2011, available at http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/120xx/doc12084/05-04-pensions.pdf.


END OF FOOTNOTES




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