How D.C.'s budget cutting harms state taxpayers

Troubles? Start with loss of federal help to the state's budget. But then there's what might happen to individuals' taxes.
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Troubles? Start with loss of federal help to the state's budget. But then there's what might happen to individuals' taxes.

Try as it might, Washington state has been hard-pressed to avoid the realities of the lingering recession, and a national report released in July by the State Budget Crisis Task Force is a fresh reminder of how states will fare under increasing federal spending cuts. 

Though the bipartisan task force has sidestepped the debates over Bush-era tax cuts and a possible trillion dollar federal spending decrease, the report doesn’t dance around their effects. Tax changes and deficit reduction, the group reported, will mean less federal revenue shared with state and local governments, a phenomenon that will be compounded by states’ eroding and often volatile tax sources.

Chaired by former Federal Reserve Board Chair Paul Volcker and former New York Lt. Gov. Richard Ravitch, the bipartisan, independent task force brought together public policy veterans and received support from state budget experts around the country and several national foundations.

According to the report, federal deficit reduction and major changes to the federal tax system will have strong effects on states and localities as revenue from D.C. shrinks over the next several years. Many of the issues addressed will be familiar to our budget experts: Affordable health care implementation (including Medicaid expansion), pension policy, and education funding are the most prominent. However, so far the likelihood of reduced federal discretionary funding has been largely missing from the radar screen in Olympia and the gubernatorial campaign debate.

The cuts could wind up slapping Washington with yet another budget deficit. Since the Congressional super-committee was unable to reach agreement in 2011, an automatic fiscal deficit reduction process will soon begin. Unless Congress amends current law by Jan. 1, cuts totaling $1.2 trillion over 10 years, equally divided between defense and non-defense programs, will begin. This is on top of $900 billion in cuts to discretionary programs already mandated.

Potential cuts in federal spending for military procurement and related items can’t be ignored since defense represents 22 percent of all federal outlays (FY2012), and is a large part of some state economies. Although Washington receives an above-average per capita level of defense spending, we seem to be better positioned to dodge the defense cut bullet, given our proximity to the Pacific Rim and the military systems under development here. 

The possible impacts of federal non-defense cuts, however, loom large for our state and generally revolve around discretionary program cuts and changes in tax policy.

Discretionary program cuts: Most discretionary programs will experience across-the-board proportional reductions. The Congressional Budget Office (CBO) projects that, even without expected federal budget cuts, non-defense discretionary spending will be 5 percent lower in 2013 adjusted for inflation.

Even if an agreement is reached on smaller short-term budget cuts, the task force believes much larger cuts are inevitable in the longer run. In that case, federal grants to state and local governments will be the primary targets of cutbacks, while defense, Social Security, Medicare, and interest payments on the federal debt will keep their funding. Medicaid will grow substantially.

Though federal government grants to states and localities — for all sorts of purposes, including transportation, education, and social services — account for only 16 percent of all federal spending, they make up more than 40 percent of the discretionary portion of the federal budget. If the grants are cut by 10 percent from 2012 levels, as the task force expects, the loss to state and local government budgets would be more than $60 billion annually. That’s twice as much as all states brought in tax increases between 2008 and 2011.

State general-fund budgets for a variety of programs, including social services, are particularly vulnerable. Washington’s 2013-2014 General Fund budget is made up of 48 percent federal dollars. Total state spending is dependent on federal funds for 23 percent of revenues.

Changes in federal tax policy: Potential changes in federal tax policy could have positive as well as negative effects on state and local governments.

The task force believes that federal tax breaks — known as tax expenditures in the world of government budgeting — will be attractive targets for federal budget-cutters because of their growth and size. Underlining that likelihood, a Congressional Budget Office report estimates that tax expenditures affecting state and local governments, such as the deductibility of state and local taxes for federal income tax purposes and the exclusion of interest on state and local bonds from federal income taxation, will grow by 36 percent from 2012 to 2015. 

In a separate analysis, the Congressional Research Service found that 20 tax breaks will account for 90 percent of the total $1.3 trillion revenue loss in FY2014. Major items are individual taxpayers' deductions or exclusions for property taxes ($27 billion), their payments of state and local income taxes ($54 billion), interest earned on tax-exempt government bonds ($43 billion), and mortgage interest ($100 billion). The task force suggests that the popular mortgage interest and tax-exempt bond interest deductions will especially be targets, since they tend to benefit higher-income individuals.

However, scaling back these deductions would have adverse impacts. The effective burden of state and local taxes would rise, and the states’ costs for capital projects would increase. The task force recommends that federal tax reform should take account the effects of such changes on state and local tax systems.

It’s not all bad news though. Two potential tax changes recommended by the task force would significantly benefit the state:

  • Deductibility of state sales tax. The deduction has had an on-again, off-again history. Eliminated in 1986, it was restored in 2004 and extended through 2011. Sen. Maria Cantwell has made its permanence one of her legislative priorities. According to the most recent year (2010) of IRS data, more than 950,000 Washingtonians took the deduction, reducing their taxable income by $2 billion and allowing that amount to circulate in the state’s economy.

But Cantwell’s effort fell through a crack earlier this year as Congress pounded out an agreement over a temporary extension of Social Security tax reductions and unemployment benefits for the long-term unemployed, while several tax breaks including the sales tax deduction were left out.

  • Online and mail-order sales. States have seen the erosion of sales tax revenues because of Internet and mail-order purchases. Although subject to the use tax (the equivalent of the sales tax for items purchased out of state), very few consumers voluntarily pay what they owe. According to the Department of Revenue, Washington state lost an estimated $465 million annually (2010 data) from these sales, which are growing year-by-year as a fraction of all retail sales.

The task force supports action to allow states to tax the sale of goods and services sold over the Internet. States have petitioned Congress to permit uniform taxation of online and mail-order sales. Our legislature passed a resolution sponsored by Sen. Debbie Regala (D–Tacoma) last year requesting that at least one of three competing bills be enacted by Congress.

But federal action has stalled. A bigger impediment may be a reluctance to pass any bill that would increase taxes, especially in an election year.

So how should Washington navigate our shrinking federal incomes? The task force commented on the need for changes in the tax structures of states to reduce revenue volatility and increase revenue predictability. It spotlighted the ongoing shift to a service economy. And it recommends that states mitigate these trends by seeking “reforms that would make their tax structures more broad-based, stable and productive.”

Although the task force didn’t study our tax system specifically, the need for change here is obvious. The state’s Economic and Revenue Forecasting Council latest quarterly report (June 2012) bears this out. Although there have been year-to-year fluctuations, the ratio of revenue collected to Washington’s total personal income has been declining since 1995 and is expected to continue that way through fiscal year 2015.

The reason: taxable sales as a share of personal income have been slipping. The retail sales tax is the largest source of General Fund revenue, accounting for 45 percent. In FY 2011, 34.5 percent of personal income was spent on taxable items, the lowest percentage on record. While construction labor, repair services, and some other services are taxed, most services — physician's visits and legal consultations, for example — are untaxed. To add to this, the growth of tax breaks has further reduced revenue.

Lastly, in the task force’s opinion, what’s missing from the mutual (federal-state-local) fiscal dilemma is a mechanism for thoroughly discussing the problem. There are limited methods in place for consulting with states and localities about the likely effects of federal cuts.

The task force recommends the formation of a permanent national-level body to study how federal deficit reduction actions or major changes in the federal tax system will affect states and localities.

And even sooner, it suggests that Congress should require the CBO to analyze ways in which major legislative proposals, whether to mandated programs, discretionary programs, or tax policy, are likely to affect the fiscal situation of state and local governments.

Washington congressional representatives, please take note. Candidates for state office should do so as well.


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About the Authors & Contributors

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Dick Nelson

Dick Nelson is a former Washington State legislator. He currently contributes to the public debate on state and local fiscal issues through research and commentary. As when he was in the legislature, he prefers the Democratic Party.