SAN FRANCISCO (S&P Global Ratings) Dec. 4, 2017–With passage in the U.S.
Senate of the Tax Cut and Jobs Act on Dec. 2, the federal-state fiscal
relationship is poised to undergo a transformational overhaul, in S&P Global
Ratings’ view. The first step in this process is the likely enactment of tax
legislation that sharply curtails the state and local tax (SALT) deduction.
But the effect of the broader tax package on the federal budget trajectory may
prove even more consequential for the states. Projections from the Joint
Committee on Taxation and the Congressional Budget Office indicate the tax
legislation could increase the federal deficit by $1.0 trillion to $1.47
trillion over 10 years. Prospects for enlarged fiscal deficits may provide
federal lawmakers renewed cause to consider making policy changes that rein in
projected federal spending, particularly in the entitlement programs. Assuming
these efforts once again focus on health care, we believe it’s plausible they
could culminate in a capping of the federal commitment to Medicaid.
If lawmakers pursued it, eliminating Medicaid’s open-ended entitlement status
would have significant fiscal implications to state finances. As much as
Medicaid is a safety net health insurance program, it’s also a mechanism for
the delivery of countercyclical federal fiscal aid to states. Since its
inception, the increased federal aid to states that occurs when enrollments
rise, such as during economic downturns, has been automatic because Medicaid
is a federal entitlement. Countercyclical federal aid arguably played an
underappreciated role in stabilizing state finances and credit quality in the
immediate aftermath of the Great Recession. Curtailing or eliminating this
dynamic could expose the states to large Medicaid-driven budget deficits in
economic downturns, likely necessitating difficult offsetting fiscal
adjustments. Potential adjustments states may consider include some
combination of limiting coverage, diverting resources from other programs, or
raising taxes. The latter of these policy options is likely to be more
constrained for some states in light of the reduced SALT deduction.
As we have previously noted, capping the SALT deduction will also likely widen
the existing balance of payment disparities among the states. That is, for
those states that raise and contribute more in federal tax revenue than they
receive in federal spending, the net imbalance is likely to grow. And by
increasing the tax burden for high income taxpayers that itemize their federal
taxes, the capped SALT deduction will attenuate the fiscal policy options
available to these states. The states are also likely to face marginally
higher future debt service costs because the legislation also ends their
ability to advance refund previously issued bonds on a tax-exempt basis
We have described the states’ fiscal integration with the federal government
as an institutional advantage that over time has contributed to strong credit
quality in the sector. In our view, the tax legislation working its way
through Congress may represent the first phase in an unwinding of this
implicit backstop that cushions state finances during times of economic
stress. Already, we have seen an increase in rating volatility in the state
sector over the past two years as a consequence of demographic and structural
economic pressures. Elevated rating turbulence, including with ratings
continuing to reach lower down the rating scale, may emerge as the norm rather
than an exception given the direction of federal policy.