What the Fiscal Cliff Could Mean for States

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State budgets are slowly recovering after a challenging few years of shrinking revenues and heavy spending cuts, but tumbling over the fiscal cliff could plunge many states right back into hardship mode.


Tax increases and spending cuts at the federal level would trickle down to state budgets, which fund many of the services that affect people’s lives most directly. But another recession in the United States, which leading economists call a likely consequence of the cliff, could hurt even more, according to Carl Lantz, Credit Suisse Head of U.S. Interest Rate Strategy.


“From the state and local perspective, the biggest problem with going off the cliff is that it seems very likely that we would have a recession,” Lantz said. “State and local budgets are still feeling the effects of the last recession, so that would be their biggest problem by far, in terms of the impact on growth.”


States would probably see sales and income tax revenue drop precipitously during a cliff-induced recession due to state residents losing jobs and pinching pennies, according to a recent report by the Pew Center on the States. States would also have to shell out more money to cover the growing rolls of programs that benefit the poor, such as Medicaid. The ranks of the unemployed would likely grow just as federal dollars that fund extended unemployment benefits expire at the end of this year.


Federal spending cuts totaling $109 billion this year would go into effect in January if Washington lawmakers fail to reach a deal on the fiscal cliff.  The across-the-board federal cuts, split evenly between defense and non-defense spending, would likely hit states hard, since federal aid helps states pay for everything from education to transportation infrastructure.


States have already suffered heavy blows from the most recent recession, which began in 2008. The Center on Budget and Policy Priorities, a Washington think tank that studies state budget issues, said recently that states have shed more than 600,000 jobs in the last four years, and in the last five years, have cut $290 billion in public services and raised taxes and fees by $100 billion.


All of those cuts arguably make federal dollars even more precious. The Center estimates that about 41 percent of the portion of the federal budget that isn’t used for defense spending, entitlement programs or debt interest payments funds grants to state and local governments.


About 18 percent of federal grants to states would be subject to cuts, the Pew Center’s report says. But because some programs, such as Medicaid, are off-limits, funding for education, public housing and nutrition for low-income women would take the brunt of the estimated $7.5 billion reduction.


States with large military presences would feel most acutely the pain of defense cuts, Lantz said. In Hawaii, for example, defense spending makes up nearly 15 percent of the state’s GDP, the Pew report said. Military spending cuts of the size currently contemplated may not be politically palatable, however, and Republicans in particular would like to avoid or reduce them.


“Most people see it as unlikely to occur in its current format,” Lantz said of the defense cuts.


Because many states peg their tax structures to current federal policy, states could see tax revenues increase if the Bush-era tax cuts are allowed to expire in a dive over the fiscal cliff, the Pew report said. But higher taxes could ultimately put a drag on local economies, as individuals slash their own spending.


Many political watchers, including Credit Suisse analysts, consider it unlikely that lawmakers will allow the country to go over the fiscal cliff and expect at least the framework of a compromise before the end of the year.


Credit Suisse Director of U.S. Rates Strategy Ira Jersey talked to The Financialist earlier this week about the fiscal cliff negotiations.



Ironically, difficult fiscal conditions over the last few years have forced many states to make some of the very changes Washington lawmakers are currently considering to reduce the federal deficit – namely, curbing spending and raising revenues. Unlike the federal government, most states cannot run budget deficits.


After enduring such hard times, no state is eager to discover what lies at the bottom of the fiscal cliff.


“Broadly speaking, the states have been making the tough decisions that the federal government has been unable to make so far,” Lantz said. “This is coming at a time when it looked like the worst was behind us for state and local governments.”