Supercommitte's Failure Gives Reprieve to State and Local Governments

WASHINGTON — State and local governments have temporarily dodged a bullet, with the bipartisan supercommittee’s failure to come up with $1.2 billion in spending cuts over the next 10 years, tax experts and lobbyists said Monday.

Sequestration — if anyone believes the mandatory $1.2 billion of automatic spending cuts will actually occur in 2013 — would be a better alternative for governments, they said. For one thing, sequestration would not result in cuts to tax expenditures such as tax-exempt interest or cuts to Medicaid, which represented 45% of total federal grant outlays to state and local governments in fiscal 2010, according to fiscal 2012 budget documents issued by the Office of Management and Budget.

In addition, half the spending cuts under sequestration would come from military programs. While those cuts could adversely affect certain states and localities, they would be limited to federal programs that more broadly impact governments.

“Sequestration is probably more friendly to state and local governments than some other kind of deficit reduction,” said Gabriel Petek, a Standard & Poor’s credit analyst who co-authored a report issued Monday called “A Look at U.S. State and Local Governments as Joint Committee Deadline Nears.”

“Medicaid is exempted from sequestration and that’s a big deal to us,” Petek added.

“I don’t know that it’s a great day for the country, but from the parochial standpoint of tax-exempt bonds, it probably means that we have dodged a bullet, at least temporarily,” said Chuck Samuels, a member of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo PC, who represents the National Association of Health and Higher Education Facilities Authorities. The committee’s inaction means no curbs on tax-exemption, he said.

S&P said in its report that OMB estimated the exclusion of interest on public-purpose state and local bonds would cost about $36.96 billion in fiscal 2012, far less than 10 of the 15 other costliest income tax expenditures for fiscal 2012. At the top of OMB’s list was the exclusion of employer contributions for medical insurance premiums and medical care, projected to cost $184.46 billion, followed by the deductibility or mortgage interest on owner-occupied homes, estimated to cost $98.55 billion.

“We are pleased that in the short term there wasn’t a short-sighted attempt to include eliminating tax-exemption as part of a balanced budget strategy,” said Lars Etzkorn, program director for the National League of Cities’ Center for Federal Relations. “If there’s going to be a continued discussion, we have an opportunity to have an informed discussion about the benefits of the partnership between state and local governments on tax-exemption.”

The American Society of Civil Engineers found in a recent report that three fourths of the infrastructure in the nation is financed through tax-exempt bonds, Etzkorn said. The report said $2.2 trillion will be needed over the next five years to meet existing infrastructure needs.

But Howard Gleckman, a resident fellow at Brookings Institution’s Tax Policy Center, said that while state and local governments don’t face cuts in the near term, they also “lose any chance of getting stimulus money this year.” Democrats on the supercommittee had talked about combining proposals for spending cuts with those for some stimulus.

And Gleckman, Samuels and Susan Gaffney, director of the Government Finance Officers Association’s federal liaison center, said state and local governments still have some shoals to navigate. More than 40 tax-law provisions and programs, such as payroll tax cuts, unemployment compensation, and tax credits, are set to expire and Congress will have to consider whether to extend them. They are estimated to cost about $300 billion over 10 years and lawmakers would have to find a way to pay for them.

“We have some relief but it may be very temporary,” said Samuels. “Don’t be surprised if we end up having to debate tax expenditures again in any discussion about these items.”

Gleckman said state and local governments “are still going to have to face budget cuts in the appropriations bills, but not as severe.”

“While the supercommittee did not produce a plan, the state and local government community must stay on their toes as these issues are not going away and Congress is likely to address tax reform and other deficit and budgetary matters in the coming months that will affect our members,” Gaffney said.

But Gleckman doesn’t see any major developments until 2013 after the November 2012 elections.

“I don’t think they ever intended to do serious deficit reduction. It was a stall until January 2013,” he said, adding he doesn’t expect sequestration will occur in 2013 either.

Meanwhile, looking to the future, S&P said that while tax reforms that reduce or eliminate the federal income tax exemption on interest earned from muni bonds could increase borrowing costs, it would probably not strain credit quality for issuers in most cases. For most states and localities rated by the rating agency, “servicing the debt consumes a modest portion of total budgets,” S&P said.

In addition, the most recent data from the Census Bureau showed that tax-exempt interest in 2009 represented 2.5% of total state government spending and 3.5% of total local government spending.

Standard & Poor’s said eliminating the mortgage interest deduction would hurt the real estate market and lead to lower property values and fewer revenues for states and localities.

The rating agency said that in the state and local governments that could be most hurt by cuts to federal spending, the federal money constituted 25% of state’s gross domestic product figures on average in 2009, ranging as high as 38% and as low as 13%. The states with the highest percentages included Hawaii at 37.6%, New Mexico at 35.7%, Mississippi at 34.8%, Alabama at 32.8%, West Virginia at 32.4%, Maryland at 32.3%, Montana at 31.2%, Kentucky at 32.1% and Alaska at 31%.

Standard & Poor’s noted that its rating on the federal government is AA-plus/negative and warned that the negative outlook means there is at least a one-in-three chance that the rating will be lowered during a two-year period. Market sources said a lower rating could lead to increases in Treaasury and muni bonds rates.

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