How Would Expiration of Bush-Era Tax Cuts Affect State and Local Budgets?

Download Special Report 187

Special Report 187

Introduction

While the U.S. economy continues its slow crawl towards recovery, many states are cur­rently in budget limbo. Last year’s stimulus bill saved state lawmakers from some politically painful fiscal adjustments, but another federal windfall is unlikely. States are wondering where to go for more revenue and what can be cut from outlays. Here we discuss how the major federal tax policy question of the day, the expir­ing Bush tax cuts, could affect states at this already tight time.

We highlight four main areas of interac­tion between state finances and the expiring tax cuts. First we discuss how potential changes in federal tax law would change state and local income tax revenue, both directly and in more subtle, interactive ways. Secondly, we discuss the impact on state estate taxes if the federal estate tax is revived after its one-year repeal in 2010. Third, because higher taxes mean less money in peoples’ wallets, we discuss the impact of various federal tax policy options on state and local sales tax collections. Finally, we discuss how the Bush tax cuts could affect the financial condition of the federal government as well as the macroeconomy, and the likely con­sequences for state and local finances.

Key Findings

• Many state income tax systems piggy-back off the federal income tax. Due to potential changes in federal taxable income, adjusted gross income, child tax credits and earned income tax credits, states that are linked closely to the federal tax code will see an automatic uptick in revenue if the Bush tax cuts expire.

• The handful of states that allow a deduction for federal income taxes paid are likely to see a revenue loss if federal income taxes increase, even after accounting for other revenue-increasing effects.

• “Interactive” effects from the expiration of the Bush tax cuts, either in January 2011 or some later date after a temporary extension, include a decrease in the value of the federal deduction for state and local taxes; a reduction in state revenues due to shrinking income and sales tax bases; and changes in tax planning by filers.

• If the federal estate tax returns there would be an automatic return of the estate tax in many states that are linked to the federal estate tax.

• Congress’s actions on the Bush tax cuts could affect the federal and state budget conditions in the long term. We briefly discuss the consequences for states of a possible federal value added tax, the possibility that declining federal credits could hurt the states’ ability to borrow, and the potential macroeconomic impacts of Congress’ handling of the Bush tax cuts.