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December 19, 2012
Fiscal Cliff Negotiators Need to Consider Impact on States, Panelists Say

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by Amy Hamilton

This article was originally published in the December 17 edition of State Tax Today.

There needs to be proper consideration at the federal level of the impact on the states of any deal between the White House and Congress on the fiscal cliff and on deficit reduction, state tax experts said December 14 during a roundtable discussion sponsored by Tax Analysts.

Christopher Bergin (Tax Analysts/Derek Squires)Not only do states face their own fiscal cliffs, they will be greatly affected by what happens in the coming weeks in Washington, said Christopher Bergin, president and publisher of Tax Analysts. (For a rush transcript of the panel discussion, see Doc 2012-25891.)

"There's a real connection between the federal budget and state budgets that many people in Washington don't spend much time thinking about," Bergin said.

A significant portion of state budgets take the form of grants in aid from Washington, Bergin said, adding that the massive federal spending cuts scheduled for 2013 -- the so-called sequester -- target this aid. States also will face threats from future efforts to reduce federal deficits, he said.

Also, Bergin said, if the continuing deadlock over the federal fiscal cliff leads to big tax increases and across-the-board spending cuts in January, the economy could be sent back into recession in early 2013. And at this point, most states are still collecting revenue at below their pre-recession levels when adjusted for inflation, he said.

Donald J. Boyd (Tax Analysts/Derek Squires)Donald Boyd, executive director of the Task Force on the State Budget Crisis and a senior fellow at the Rockefeller Institute of Government, said states have already gone over their own fiscal cliffs and are now "limping up from the bottom."

The drop-off in state tax revenue since 2008 is extraordinary, Boyd said, adding that what's not widely understood is that the areas of the economy where most states derive revenue have recovered much more slowly than the broader economy.

Nicholas Johnson (Tax Analysts/Derek Squires)Nicholas Johnson, vice president for state fiscal policy at the Center on Budget and Policy Priorities, agreed. "This wasn't just a recession," he said. "This was the worst economic falloff in 70 years." Not only are states still collecting revenue at below pre-recession levels, it will be several more years before they recover, he said.

Meanwhile, panelists said, the state corporate income tax is broken, the sales tax was designed for goods and not services, and the property tax now applies to values that don't apply to fair market value.

Johnson pointed out that personal income taxes are failing to capture growth at the top end of the scale. He also said that about half of the states are under the control of one political party with veto-proof majorities, and that one upshot is bad tax policy. A few states are now giving full or partial tax exemptions to all the income of passthrough entities, for example, which he said amounts to a tax break for a lot of entities that aren't small businesses and aren't job creators.

Joseph Henchman (Tax Analysts/Derek Squires)Joseph Henchman, vice president of legal and state projects for the Tax Foundation, said federal and state lawmakers are in denial about their inability to pay for many services that the government has committed to providing.

At the federal level, there's been a lot of discussion about distribution and the top 1 percent, Henchman said. But there's not a lot of discussion about how to encourage economic growth so all governments can afford to meet their commitments without breaking the bank.

"The pie's not growing," he said. "We're fighting over the scraps, and it's not going to be pretty."

"How do we get our national growth rate up? That question is the elephant in the room," Henchman said, adding that states can nibble around the edges but the issue is one determined largely by national policy.

Cara Griffith (Tax Analysts/Derek Squires)State Tax Notes legal editor Cara Griffith noted the concern about eliminating the deduction for state and local taxes, which she said amounted to an indirect $67 billion subsidy to state and local governments in 2011. Forgotten in this discussion, said Elliott Dubin, the director of policy research for the Multistate Tax Commission, is the fact that the federal alternative minimum tax is already starting to limit the usefulness of the state and local deduction.

Griffith said that while the scheduled federal spending cuts are a threat to the states, it's not necessarily all bad news for the states if an agreement isn't reached on the expiring federal tax cuts. Changes in the estate tax, for example, could result in increased state revenue.

Boyd said that while broadening the federal tax base is not part of the current deficit reduction discussions, the federal government's need for revenue isn't going to go away in the next several weeks or months. The federal government then might take the lead in broadening the federal income tax base.

He said the biggest thing the federal government could do to assist the states in strengthening their tax bases would be to have a broad-based federal income tax and not to impose a national sales tax.

"And maybe the first rule is to do no harm," Bergin said.

Amy Hamilton

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