Expiring Taxes, Politics Threaten States’ Strong Fiscal Shape

Most states are in solid fiscal shape, but the good times might not last much longer amid a slowdown in federal dollars, analysts said Monday during a panel at the National Conference of State Legislatures legislative summit in Indianapolis.

Massive federal funding from the two most recent presidential administrations and a resilient economy have helped states maintain their spending patterns while increasing their rainy-day funds, but challenges loom on the fiscal horizon. Remote work has eroded urban tax bases. Unexpected disasters like a single cyberattack that could cost as much as $100 million. In addition, political clashes in Congress threaten state finances in a range of ways.

“It is a long and winding road and you never know what is around the next curve,” said Erica MacKellar, program principal at the NCSL during the discussion on state fiscal trends. “The potential for a recession seems to lessen somewhat, but there’s still a lot of economic uncertainty out there.”

Panelists alluded to how many states appeared on the brink of fiscal collapse after the Covid-19 pandemic began. Federal spending ultimately prevented business failures and widespread unemployment. States experienced increases in revenues from taxes on sales and personal income with inflation driving prices and wages. Extra stimulus funding to states added billions to their rainy day funds.

Some states now have roughly twice as much cash in reserve compared to just a few years ago, according to panelist Geoffrey Buswick of S&P Global Market Intelligence. “Prior to the pandemic, we saw states have around 10%,” he said of their percentage of budgeted expenditures in reserve. “Right now we’re seeing those numbers at close to 20%.”

That increase has helped states maintain high credit ratings that decrease their borrowing costs, he said.

‘Do Not See This Ending Well’

State officials face uncertainty at the federal level in trying to forecast their future.

Many of the provisions of the 2017 federal tax law will expire by 2025. That leaves the future of the child tax credit, the estate tax exemption, and individual income taxes up in the air, which is especially problematic considering how many states have directly tied key parts of their own tax codes to federal law, MacKellar noted.

“There’s a lot of uncertainty at the federal level about if they’ll be extended or if they won’t,” she said. “Given the current rhetoric that we see at the federal government, it’s tough to imagine a big ‘Kumbaya’ moment for something like that.”

Cities might increasingly lean on state governments to help them overcome their own declining revenues, according to Buswick. Roughly one-third of workers who previously came into the office are now staying home during the workday, decimating commercial real estate values in the process. Increasing home values could mitigate some losses, he said.

“We do accept some cities to have a harder time managing than others,” Buswick said.

Big cities in California and New York are already having trouble getting fiscal help from their respective states as lower-than-expected tax revenues, inflation, and stock market turbulence have created multibillion-dollar deficits. The Empire State also faces spiraling Medicaid costs.

Disruptive tech advancements could also take a toll on the bottom line. “How is artificial intelligence going to become a disrupter in what we do and how we do it?” Buswick asked.

Potential problems: Many jobs could get automated in ways that slash state income tax receipts. Cutting-edge companies also could find new ways to evade taxes.

Hackers, whether human or aided by AI, could also pose a big fiscal blow to any state. The 2021 ransomware at Scripps Health in California, cost more than $100 million, Buswick noted. “So I don’t care how large your budget is—you start having to reallocate [so much money] you’re going to change budget decisions,” he said.

The federal government has historically helped states when they face fiscal disaster. Such assistance reached a massive level during the pandemic, but political dysfunction in Washington could result in fewer funds, said Marcia Howard, executive director of the Federal Funds Information for States, a think tank that tracks the topic.

A significant funding gap has already emerged in proposed spending levels supported by the GOP-controlled House and the Democratic-led Senate on a wide range of fronts. “If you’ve noticed there’s about a $50 billion gap in the Labor, Health and Human Services, and Education appropriation bill, which guess what? [That] is where you get all your money,” she said.

She added that she is pessimistic about the coming months.

“We will be dusting off our government shutdown materials as soon as Congress comes back in September because we do not see this ending well,” Howard said.