Heartland States on High Alert Over Fiscal Cliff

By The Fiscal Times  NOV 26, 2012 4:00 PM

State and local officials in the US heartland are steeling themselves for the possibility of a major loss of tax revenue, federal aid, and grants next year.

 


In a recent call with reporters, Democratic Sen. Tom Harkin of Iowa signaled he was willing to let the country topple over the fiscal cliff unless President Obama and Congress strike a deal to force wealthy Americans to pay more in taxes and that protects Medicare and Medicaid from deep cuts.

“No deal is better than a bad deal, because things will change after Jan. 1, the positions will change,” Harkin explained. “Quite frankly, if we don’t get a good deal, we’ll just take it up in January or February."

But other Iowa officials have a less cavalier view of what would happen if Obama and congressional leaders fall short of negotiating an agreement to block the more than $600 billion of tax increases and spending cuts that are set to take effect beginning Jan. 2.

Iowa Gov. Terry Branstad told The Iowa Gazette that the potential impact to the Hawkeye State could be “grave.” The Republican governor noted that a sudden increase in the federal estate tax would hurt farmers and small businesses and that cuts in defense spending could lead to a loss of jobs at the Rockwell Collins aerospace and defense company in Cedar Rapids. In September, Rockwell Collins announced as many as 1,000 employees may have to be laid off, including 350 directly related to the potential federal spending cut and others due to declining defense spending.

Just as Washington policymakers and politicians are obsessing on the damage that the fiscal cliff poses to the national economy and jobs picture, state and local officials in the U.S. heartland are steeling themselves for the possibility of a major loss of tax revenue, federal aid, and grants next year.

While practically every state is certain to experience some economic turmoil if the country tumbles over the fiscal cliff, Iowa is one of only six states that could suffer a double whammy of declining state revenues and a significant loss of federal aid. The Iowa Department of Revenue estimates that state income tax revenue could decline as much as $90 million during the first six months of 2013, and $200 million to $300 million during fiscal 2014 because of a quirk in the state’s tax code.

State programs, moreover, would likely receive $52.9 million less than expected in the current year because of the automatic reductions in federal spending mandated under last year’s debt ceiling legislation, according to a recent study by the Iowa Legislative Services Agency.

State officials and analysts hasten to say that the revenue losses would be far from cataclysmic in a state that raises more than $4 billion annually in individual and corporate income tax revenue. Moreover, the reductions in federal aid would represent a relatively small percentage of the total annual amount.

Amid fears that the lethargic economy might slip back into a recession next year, the specter of declining state revenues and federal aid will greatly complicate the task of many state legislatures and governors in balancing their budgets while meeting essential needs, according to experts. “It’s not going to wipe us out, but $200 million or more [of lost revenue next year] is a lot in the legislature when they’re trying to fund programs,”  Amy Harris, the Department of Revenue’s manager of tax research and program analysis, told The Fiscal Times. “So certainly one should pay attention, and we certainly need to consider that when budgets are being set.”

Many state officials had been counting on another good year of revenue growth and improving economic conditions after years of budget shortfalls throughout the Great Recession. But with parts of the East Coast devastated by Hurricane Sandy and the possibility of a year-end federal fiscal calamity, governors and state officials across the country are on high alert.

According to a new study by the Pew Center on the States, the general economic slowdown that would result from a combination of expiring tax-cut provisions and across the board defense and domestic spending cuts early next year would significantly affect state economic activity and indirectly undercut many state budgets.

Because federal and state finances are so closely intertwined, the tsunami of expiring Bush-era tax cuts and the budget cuts or sequester would hit the states in a multitude of ways. Most of them would either win or lose depending on the extent of their dependence on federal aid, grants and defense contracting, and the details of their state income tax laws.

For example, Iowa is one of six states that allow residents to deduct federal taxes from their income in filing state tax returns. The others are Alabama, Louisiana, Montana, Missouri and Oregon. These states stand to lose substantial state revenue if all the Bush-era federal tax cuts and other provisions expire by the end of the year. That’s because the more those residents are charged in federal taxes the less they pay in state income taxes.

”The amount of withholding that we get from employers and employees’ paychecks is a function of their wages and the amount of federal withholding,” Harris said. “So if federal withholding were to go up, ours goes down.”

Harris added that if Congress and the administration declines to extend a payroll tax cut that is also set to expire, “We estimate that is about a billion dollars less of disposable income for us during 2013, so that’s less spending and sales tax revenue. But the direct impact of course is through federal deductibility and withholding.”

Conversely, for the 43 states and the District of Columbia that levy a personal income tax, most of them would see an increase in revenues in the coming year if Obama and Congress allow the tax cuts and other deductions to expire. That’s because those states link their tax systems to the federal revenue code by adopting various federal definitions of income or various federal deductions and credits.

If the tax cuts are allowed to expire, that would mean – for example – the reinstatement of limits on some deductions for high-income taxpayers (estimated to increase 2013 federal revenues by $6.1 billion) and the elimination of the deduction for higher education tuition and fees (nearly $1 billion). Depending on a state’s tax code, lower federal deductions could automatically result in more income taxed at the state level as well, which would increase state revenue. The bad news is that the more than $100 billion of automatic across-the-board spending cuts would deliver a serious blow to many states that have grown accustomed to substantial federal aid and procurement. This is particularly true in states such as Maryland, Virginia, New Mexico, Kentucky, and Hawaii that are home to substantial defense industry facilities and military installations and that benefit from much higher than average federal spending.

In Iowa, the projected loss of an estimated $52.9 million a year would include $9.3 million in special education funding, $6.4 million in education funding for low-income students and $4.5 million for Head Start pre-school programs — roughly a 7.5 percent funding decrease in each program. But the overall loss in federal funding would be only about 2 percent. That’s because the lion’s share of federal aid to Iowa is Medicaid for the poor, which is exempt from the across the board cuts or sequestration.

“That said, when certain programs are hit harder than others, those programs could lay off one or two staff members or shut down a program completely to reallocate funds to a different area within that field,” explained Aaron Todd, a legislative analyst with the Legislative Services Agency. “So it does have real impact.” He added, “In terms of sequestration, we’re just kind of in the waiting mode. Like everyone else, we’re trying to read the tea leaves.”

Editor's Note: This article by Eric Pianin originally appeared on The Fiscal Times.

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