Fiscal cliff: Will the states tumble, too?

As Congress and President Obama continue to spar over how to avoid the looming fiscal cliff, most public attention has been focused on what tumbling over the edge would mean for the federal budget and the national economy. But the tremendous uncertainty over the threat of tax increases and cuts in federal spending could cause big problems for state budgets as well.

Two new studies, one by The Pew Center on the States and another by the Tax Policy Center, show what falling over the cliff would mean for states. There is a sliver of good news: If all of the last decade’s tax cuts are allowed to expire, states might see a short-term boost in revenues. They might, that is, if the economy isn’t thrown back into recession.

The Pew report, The Impact of the Fiscal Cliff on the States, takes a comprehensive look at how the states will be affected by gridlock. State revenue is dependent on the feds, with $1 in every $3 coming from federal grants in 2010. While Medicaid, one big source of federal dollars, is exempt from the automatic across-the-board spending reduction due to take effect in January, eighteen percent of federal grants to states will be subject to those cuts in FY 2013.

On the tax side, the picture is murkier. Because many states link their tax codes to the federal law, if all of the tax cuts expire and revert to pre-2001 law, states could benefit when some elements are restored. For instance, the old limitation on itemized deductions for high-income taxpayers would increase taxable income and some states could enjoy new income tax revenue.

For example, take the estate tax. I looked at what would happen to that levy in a new TPC paper called Back from the Dead: State Estate Taxes after the Fiscal Cliff.

In 2001, in what Congress hoped would be the first steps on the road to full repeal of the estate tax, lawmakers temporarily phased out a credit for state estate and inheritance taxes, In 2005, the credit was replaced with a less-generous deduction. Some states responded to these changes by simply repealing their estate taxes. Others decoupled from the federal law, either establishing a stand-alone tax or explicitly linking their taxes to the old 2001 law. But many states did nothing, which left their estate tax tied to the repealed federal credit.

Now, if Congress goes over the cliff and the estate tax reverts to the 2001 law, 30 states will once again benefit from the resurrected credit, and their revenues will rise by about $3 billion.

That’s potentially good news, of course, for states still struggling to recover from the recession. But the promise of higher estate tax revenues could easily be swamped by those across-the-board cuts in federal spending or, worse, another recession. On the other hand, if Congress kicks the proverbial can down the road and delays efforts to address its fiscal challenges until next year, states (like businesses) must try to budget in a period of ongoing uncertainty. Both of these new reports highlight the links between states and the federal government and underline the need for clarity and permanence in federal fiscal policy.