Going into the fiscal cliff negotiations, state and local governments had two major concerns: the sequestration cuts mandated by the 2011 Budget Control Act, and the fate of certain tax expenditures, such as for municipal bond interest and state and local taxes paid. Sequestration was delayed and tax exemptions were mostly untouched (excepting the reinstatement of the so-called Pease and PEP limits for high-earners). Thus state and local governments are today quite relieved.
But only for now. The next round of negotiations over the debt ceiling will begin soon, and presumably include sequestration, since the federal debt limit will be reached roughly around when the cuts are timed to begin. Raising the debt limit is something Democrats have to persuade Republicans to do. The question is therefore what Republicans will get in return. Protecting defense against sequestration has relatively strong bipartisan support, but the non-defense sequestration cuts now look quite probable. Since Democrats are not going to want to give Republicans tax cuts so soon after securing the "first significant bipartisan tax increase since 1990, when former President George H.W. Bush violated his 'read my lips' promise on taxes," chances are that Democrats will have to budge on spending to raise the debt limit. This will mean cuts to non-defense discretionary programs and/or long range entitlement reform.
In any event, we should expect the National League of Cities, the US Conference of Mayors and suchlike to redouble their efforts to prevent nondefense cuts. We should also remind ourselves that there are good reasons to think sequestration would not be catastrophic for state and local governments.
As for the $100 billion + in federal tax breaks that directly benefit state and local governments, their fate will linked to whether Congress and President Obama take up comprehensive tax reform. Both House Ways and Means Chairman Dave Camp and Senate Finance Committee chairman Max Baucus have vowed to pursue tax reform in 2013, and President Obama has also expressed interest. The muni bond exemption and itemized deductions could be addressed in the debt ceiling deal, but this is more speculative. During the fiscal cliff negotiations, from the Republican perspective, the most compelling reason to accept a cap on exemptions for high earners, was that it was a better way to raise revenues than rate hikes. But it will be hard for Democrats to push for more revenues in coming months; their focus is likely to shift towards protecting spending programs as much as possible. The politics of tax reform thus look different, post-fiscal cliff deal. Arguably, Republicans (Democrats, too, for that matter) are now in a better position to push for real tax reform, untainted by revenue demands. Much will depend on what Democrats will agree to do vis-à-vis rates.