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Heartland States on High Alert Over Fiscal Cliff

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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.

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"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.
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