States left 'unstimulated' by tax cut deal

December 9, 2010 — President Obama’s recent agreement with the GOP leadership to extend all the Bush tax cuts included a series of other provisions. Among them: a 13-month extension of unemployment benefits, a temporary payroll tax cut, and an extension of the Earned Income Tax Credit and other targeted tax cuts that were set to expire.

The deal is being touted by some of the proposal’s supporters, including some influential economists, as a second, most likely final, round of fiscal stimulus.

With federal aid running out, reserves fully tapped, and many revenue-boosting options already explored, public sector job losses are likely not just to continue but to “accelerate,” said Chris Whatley of The Council of State Governments.

At the same time, however, the package appears to mark a definitive end to an important element of stimulus policy: relief to strapped state governments. While states are expected to continue shedding workers and cutting services for the next several years even as the economy recovers, a continuation of spending assistance to states was apparently not considered during the negotiations that led to a tentative agreement between Obama and the GOP.

The fate of a much smaller measure designed to lower state borrowing costs, meanwhile, hangs on further talks. And, in its emphasis on tax cuts over other forms of stimulus, the package may in some cases worsen the state fiscal crisis, according to an analysis by leading state budget observers.

Unlike the federal government, almost all states are barred from running budget deficits. As a result, when the economy goes into recession and revenues decline, state governments often respond, in part, by laying off workers. That leaves states less prepared to meet the increased demand for services in a bad economy. It also worsens the economy, because laid-off state employees have less money to spend.

The current recession brought about some of the largest state revenue declines on record, leading to a cumulative budget shortfall of approximately $190 billion in fiscal year 2010 alone. To cushion the blow, the federal government provided $140 billion to states over two and a half years as part of the initial stimulus package, mostly to offset rising Medicaid costs and help cover education and public safety expenses. In August, Congress approved another $26 billion.

That money preserved some jobs: about 47,000 school positions in California alone in the second quarter of 2010, according to data filed with the U.S. Department of Education. Still, 44 states and the District of Columbia have pared their workforce; all told, according to a recent report by the Center on Budget and Policy Priorities (CBPP), state and local governments (which depend on states for support) have eliminated more than 400,000 jobs since August 2008. In recent months, as private sector hiring has started to pick up, the public sector has continued to shed jobs. Eleven thousand public sector jobs were lost in November, partially offsetting the 50,000-job gain in (mostly temporary) private-sector employment. (With the labor force growing, the unemployment rate actually climbed to 9.8 percent despite the net job gain.)

And the situation at the state level is about to get worse. “We think that states may be facing their most difficult year yet in 2012,” said Phil Oliff, a policy analyst for CBPP. That is because nearly all the aid authorized by Congress will have run out by June 2011, when states are setting their fiscal 2012 budgets. Meanwhile, state revenues have started to recover modestly, but remain well below 2008 levels. Projections are tentative at this point, but CBPP foresees a total shortfall of about $140 billion at the state level in 2012.

Further federal aid to states could soften those cuts. It would also, according to leading economic models, be among the most stimulative ways for the federal government to spend money: the Congressional Budget Office recently concluded that compared to other parts of the Recovery Act, non-infrastructure aid to states did almost as much to boost the overall economy as payments to individuals like unemployment insurance, and more than any class of tax cuts.

“We’re talking about how many jobs this creates, and what the economic impact is, but for whatever reason, we’ve decided to leave the most effective arrows in our quiver,” said Michael Linden, associate director for tax and budget policy at the Center for American Progress.

Despite the logic of further state aid, and the apparent opportunity created by the tax cut talks, the topic seems to have been nearly absent from the recent negotiations. Representatives for state governments said leaders in Congress had already made it clear that they had no appetite for extending the major spending provisions of the Recovery Act — and that states, having gotten the message, had mostly stopped asking.

“The prospects of getting any more [Medicaid] or education jobs funding is about nil,” said Whatley. “There is a clear aversion … to fund anything that squawks like the stimulus.” Michael Bird, federal affairs counsel for the National Conference of State Legislatures, said he had received the same message. After the August jobs bill, “we were told, this is going to be it,” he said.

On smaller provisions, meanwhile, states are still pushing their case, but to limited effect. One such initiative is the Build America Bonds program, under which federal subsidies allow state and local governments to obtain lower interest rates on long-term debt for infrastructure projects. The program is slated to expire Dec. 31; according to Whatley, estimates of the cost to the federal government for a 10-year extension range from about $2.7 to $4 billion, depending on how many bonds are sold.

Organizations such as CSG and NCSL, as well as individual state leaders, have been lobbying for an extension of the program, and a group of nine Democratic senators is now pushing to insert the provision into the broader tax deal. But the outcome remains in doubt. “We just can’t get through with the Republicans to go along with us,” said Bird.

Representatives for state governments said leaders in Congress had already made it clear that they had no appetite for extending the major spending provisions of the Recovery Act — and that states, having gotten the message, had mostly stopped asking.

If further spending is out, one of the tax measures in the deal may actually worsen the revenue situation for some states. The package includes a provision, first sought by the White House in September, that will allow businesses to deduct 100 percent of the cost of new investments from their tax liabilities upfront, rather than depreciating them over their lifespan.

The change makes sense for the federal government because it will ultimately recoup much of the nearly $200 billion short-term cost over the next decade (deductions taken now can’t be used to offset income in out years) — and encouraging businesses to shift investments forward may help the economy at a time of continuing fragility. Linden and his colleague Michael Ettlinger have estimated the provision could help support up to 260,000 jobs through 2012.

But it could hurt state budgets now, too. That’s because in about half the country, taxable income for state purposes is defined as whatever way the federal government defines it; a federal deduction automatically becomes a state deduction. In much of the rest of the country, that conformity isn’t automatic, but it is routine. A CBPP paper last month warned that because of these linkages, a similar proposal could cost states $20 billion in revenue between 2011 and 2013 — and while states would also recoup most of those funds over the next decade, unlike the federal government, states cannot run deficits in the meantime.

“The additional state revenue losses resulting from the proposal would make it necessary for states to enact additional budget cuts or tax increases, which would reduce the proposal’s overall stimulative effect,” the organization wrote.

It was not immediately clear how large an effort was underway to press this issue before Congress or the White House. Whatley and Bird said they agreed the impact could be harmful, but their groups had not taken a formal position, because the effect would vary for different states.

Linden, for one, said it is possible that as 2012 approaches and the budget crises loom closer, governors of both parties may press the case for more federal aid, and Congress may revisit the issue — just as extended unemployment insurance was folded into the current tax talks at a time when millions of Americans were soon to lose their benefits.

Both Whatley and Bird, though, said they thought that was unlikely. Even before the latest election, Whatley said, “states had realized it was going to be up to them to deal with their 2012 budgets” — and with another round of service cuts and layoffs on the horizon, he does not expect that to change.