White Paper 2012-11
THE BLUE STATE TAX CRUNCH
A new and unfavorable picture of the state implications of the impending federal fiscal cliff is coming to the fore. State budgets will be stressed by sequestration but it is the state economies which will present the real problem. Any material balancing of the federal budget will quickly reduce overall US GDP and necessarily the GDPs of the state economies. The impacts of federal proposals, however, are far from uniform among the states. The largest Democratic voting states, the Blue states, are facing potentially dramatic wealth declines. Fixing the federal fiscal cliff will likely cause regional recessions in the Blue states even if a recession for the country is avoided.
And it is a double-edged sword. Increasing federal taxes will increase state tax revenue in most states since their state codes are tied to the federal code. That produces an economic hit to these states, resulting from increasing both the federal and state income taxes. The governments gain revenue at the expense of the private sector.
This paper asks two questions. What can we expect in US GDP and how will it be distributed among the states?
The impact of proposed changes in federal and state income taxes is a combination of expanding the tax base and raising the tax rate. The tax rate impact, already large at the federal and state level, is scheduled to rise sharply as Table 1 shows. In New York and California, marginal rates will rise to over 50%. While these rates are, in and of themselves, stunning to many Americans, the overall tax impact is even greater than they suggest because the tax base is broadened.
The impact on US GDP of sequestration and tax increases is generally expected to be around negative 4% of GDP next year if they are fully implemented. We would expect a phase in of many of the scheduled budgetary and tax items. But the phase in has its risks, too. Unless a material reduction in the deficit occurs in a reasonable time, a substantial downgrade in the rating of US Treasury debt should be expected. There are many unknowns among the risks facing the country, but the long term impact of another rating decline for the US may well end up costing more than a recession. Nor is the 4% GDP decline the worst. Other estimates are even more severe. The Tax Foundation expects a decline of 9.61% over the next ten years.
Impact to vary by state
State budgets are a mixed picture with many states receiving higher tax revenue but facing some loss of funds through sequestration. Nevertheless, that is hardly the end of the story for the states. The decline in economic activity resulting from tax increases will be concentrated in a few states because taxes are focused in those states. Chart 1 shows that cumulatively the top ten federal tax paying states account for a little less than 60% of federal tax. That concentration may well increase after a new set of tax increases eliminate most or all of the itemized deductions. See Chart 2.
The economies of large, already high tax, Blue states are particularly vulnerable to the macroeconomic consequences of fixing the federal fiscal cliff. Depending on exactly how taxes are increased, we may well be headed for a Blue credit crunch.
Chart 1. Federal tax by state in 2010
Chart 2. Total itemized deductions by state in 2010 – cumulative percent
Source: Internal Revenue Service Data Book, 2010, Publication 55B, Washington DC, March 2011, accessed
Source: “SOI Tax Stats - Historic Table 2,” IRS, last modified December 08, 2012,
Source: See Scott Drenkard, “New Federal-State Rate Calculation in Full Fiscal Cliff/Obamacare Scenario,” Tax Foundation Blog, December 07, 2012, http://taxfoundation.org/blog/new-federal-state-rate-calculation-full-fiscal-cliffobamacare-scenario; and Gerald T. Prante and Austin John, “Top Marginal Effective Tax Rates by State and by Source of Income, 2012 Tax Law vs. 2013 Scheduled Tax Law,” Working Paper Series, Lynchburg College, School of Business and Economics, November 15, 2012, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2176526.
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 Mark Silva, “Fiscal Cliff’s ‘Stark’ Impact: 4% GDP,” Political Capital on Bloomberg.com, October 10, 2012, http://go.bloomberg.com/political-capital/2012-10-10/fiscal-cliffs-stark-impact-4-gdp/.
 Jeremy Ratner, “The Impact of the Fiscal Cliff on the States,” Fiscal Federalism Initiative on Pew Center on the States online, November 15, 2012, http://www.pewstates.org/research/reports/the-impact-of-the-fiscal-cliff-on-the-states-85899430339.