How federal budget woes impact state and local governments

With the Eurozone on its way down the austerity path and the European Central Bank (ECB) estimating two consecutive years of GDP contraction, all eyes were on the United States as it approached the Dec. 31, 2012, deadline to avert the automatic tax increases and spending cuts that would jump-start a 10-year plan to reduce its national deficit by $1.5 trillion. Whether or not an alternative to the deficit reduction plan is negotiated, state and local government budgets will be affected directly and indirectly.

The Pew Center on the States' November 2012 report, The Impact of the Fiscal Cliff on the States, points out that federal and state finances are closely linked. "When certain expiring tax provisions within the fiscal cliff are analyzed independently, they could increase state revenues," according to the Pew report, which lists these examples:

• For at least 25 states and the District of Columbia, lower federal deductions would mean higher income taxed at the state level.

• At least 30 states and the District of Columbia would see revenue increases because they have tax credits based on federal credits that would be reduced

• Thirty-three states would collect more revenue as a result of changes in the estate tax.

However, for the six states that currently allow deduction of federal taxes, higher federal tax rates would translate into reduced state revenues.

Federal spending cuts in grant dollars (about 18 percent), procurement, salaries, wages and defense stand to impact some states more than others.

Federal grants account for 5 to 10 percent of state revenues (6.6 percent is the average).

Federal non-defense spending on procurement, salaries and wages, when compared to state gross domestic product (GDP), is almost 20 percent of the DC-Maryland-Virginia GDP. The next top 4 states impacted by non-defense spending are Hawaii (16 percent), Alaska (13 percent), New Mexico (13 percent) and Kentucky (10 percent). The national average is 5.3 percent of GDP.

Federal defense spending on procurement, salaries and wages is nearly 15 percent of Hawaii's GDP, and a major factor in other states, too, including Alaska (11 percent), DC-Maryland-Virginia (10 percent), Kentucky (8 percent) and Alabama (7 percent). The national average is 3.5 percent of GDP.

The above highlights the direct impact of the various tax elements associated with the fiscal cliff. The broader implications of indirect effects are less clear and thereby provide the greater cause for uncertainty and concern. The Pew report observes that if all of the tax increases and spending cuts are allowed to take place, the impact on individuals and the economy could "significantly overwhelm any of the direct impacts."

Where does that leave us? Barring the fiscal cliff, economists predicted an economic growth rate for 2013 of 3 to 3.5 percent. As it stood at year-end, growth would be curtailed to a net of about 2 percent, prolonging an already slow period of recovery. The trade-off to cuts and higher taxes today is a future of even greater federal deficits and debt servicing as a percentage of annual spending. At the end of 2012, the U.S. federal debt was $16.3 trillion, 102 percent of annual GDP, and a level not seen since World War II. Without correction, the U.S. is on course to compound its deficits at the rate of 4 to 6 percent per year.

While philosophical debate continues behind the scenes as to a meaningfully relevant level of debt, what the public, financial community and global community expect at this time is an indication of greater fiscal stability into the future. Well, as Yogi Berra put it, "It ain't over 'til it's over."

Brent Maas is Executive Director, Business Strategy & Relationships for NIGP: The Institute for Public Procurement. Email [email protected].

Deficit Reduction Resulting from FY13 "Fiscal Cliff"

U.S. Budget Projections (Shown in US$ Billions)