• Mission & Governance
• Services Overview
• How to Get Involved
• Standing Committees
• NCSL Foundation

• Issue Areas: A-Z
• State-Federal Relations
• NCSL Standing Committees
• News from D.C. and the States

• About State Legislatures
• Elections, Campaigns & Redistricting
• NCSL's StateConnect Directory
• Web Sites

• Online Guide to NCSL Services
• Staff Sections and Networks
• Meetings & Professional Development
• Staff Directories

• Meetings Calendar
• Online Registration
• Meetings Home Page
• Legislative Summit

• Bookstore
• State Legislatures Magazine
• NCSL's StateConnect Directory

The Impact of Federal Tax Policy
Decisions on States' Budgets

Alysoun McLaughlin
Senior Federal Budget and Taxation Specialist

State governments have a primary role in providing services such as public education, transportation, and water supply and in ensuring public health and safety. The federal government assists the states in providing these vital public services through grants in aid, which represent roughly 25 percent of total state spending. Consequently, when the federal government changes its spending policy, states must adjust their budgets to accommodate changes in the flow of federal spending.

The relationship between federal and state tax policy, however, is less frequently discussed and is generally not well understood. Although sales and property taxes are administered independently of the federal government, state income taxes and certain other sources of state revenue are based on rules and definitions in the federal Internal Revenue Code. States rely on federal reporting for auditing and enforcement. As a result, certain kinds of changes in federal tax policy can have substantial consequences for the states. The extent of these consequences generally depends on how closely state taxes are tied to the federal tax.

The practice of mirroring federal tax provisions at the state level - referred to as "conforming" - promotes compliance and simplifies tax administration. However, it also carries a risk that state revenues will rise and fall with changes in federal tax policy.

State practices in this area differ greatly. Some states' laws were written to provide many of the same benefits as the federal government. Other states' laws contain an explicit link to the definitions and deductions contained in the federal code. Many states use a federal "starting point" instructing state taxpayers to begin their calculation of state taxes owed by copying a specific line from their federal tax return – either line 33 (adjusted gross income) or line 39 (taxable income). Some states conform to provisions in the federal code as it is currently in effect, while other states conform as of a date certain. These states usually update their conformity provisions on a regular basis. Until 2001, Vermont, Rhode Island and North Dakota calculated state taxes starting from federal tax liability. Consequently, state revenues rose and fell with changes in federal marginal rates. Each of these states enacted legislation in 2001 to change their starting point.

As a result of states differing practices on conformity, the impact of federal tax changes on state revenues also differs greatly. Usually, the state has an option to conform or not. A state may choose to conform to some, but not all, of the federal tax changes adopted during the year. Depending on state law, this may be accomplished by passing legislation to conform, by passing legislation to decouple from the federal tax code, or through inaction. Depending on the nature of the federal tax change and the mechanism that states use to conform or decouple, a decision not to conform will present a greater or lesser burden for the taxpayer. For example, a decision to use a separate schedule for depreciation than the federal government may pose a substantial administrative burden on corporations within the state. A decision not to mirror a specific federal tax credit, however, poses a relatively low administrative burden for the taxpayer.

As a rule, when federal taxes go up or down, so do state taxes. However, there are broad exceptions to this rule. First, not all federal tax changes result in a change in state tax revenues. Changes in federal marginal rates and tax credits, for example, do not generally have an effect on state revenues because they are calculated on the federal 1040 after line 39. Second, five states - Alabama, Iowa, Louisiana, Montana and North Dakota - allow a deduction for federal taxes paid. Federal tax legislation usually has less of an effect on revenues in these states because changes in revenue from the deduction for federal taxes offsets the changes in revenue for the state to conform under its own tax laws.

For more information, contact Alysoun McLaughlin, Senior Federal Budget and Tax Specialist, or see the following related reports on NCSL’s web site:
Recent Federal Tax Legislation and the States (August 2002)
Economic Stimulus Proposals: Impact on States (January 2003)