Federal Tax Reform and the States

4/1/2018

Tax ReformAt the end of his first year in office, President Donald Trump signed into law the largest overhaul of the nation’s tax code since 1986. What began as a U.S. House of Representatives Republican framework on June 24, 2016, known as "A Better Way," culminated into a final bill, the Tax Cuts and Jobs Act (TCJA) (H.R. 1), which became law on Dec. 22, 2017.

The following analysis details how changes to federal law could affect state revenues and tax administration by highlighting big picture fiscal considerations, personal income tax (PIT), corporate income tax (CIT), and other notable provisions. Individual state analyses are highlighted at the end of the page.

Big Picture Fiscal Considerations

Federal Spending Constraints

The Dec. 15, 2017 Congressional Budget Office analysis of the TCJA found that without taking into account macroeconomic effects, the law will increase the deficit by $1.46 trillion dollars over the next 10 years. That number could swell, however, if the temporary individual cuts that are set to expire at the end of 2025 are renewed by a future Congress. Moreover, the Joint Committee on Taxation projects the TCJA will add approximately $1 trillion to the nation’s debt, even when economic growth is accounted for. This acceleration of the growth of the nation’s debt will likely elevate pressure to constrain spending at the federal level.

More states are experiencing tight budgets than at any point since the Great Recession. Spending for major programs, such as Medicaid and education, is generally outpacing revenue growth. A reduction in federal transfers, which make up roughly one-third of overall state revenues, could present significant long-term challenges for state budgets.

After the tax reform effort in 1986, growth in federal aid to states was noticeably reduced. According to research performed by the Federal Reserve Bank of Chicago, the cumulative federal grants-in-aid to state and local governments increased by 6.4 percent from 1982-1986, but they only increased by 3.9 percent from 1986-1990. 

Sun-Setting of Individual Tax Changes

Most of the changes to the individual tax code are temporary, expiring at the end of 2025. States will need to be cognizant of a potential reversal in eight years, particularly those who realize more revenue by conforming to federal base-broadening.

Creating New Loopholes?

Tax experts anticipate the legislation may create new complexities in the tax code that provide opportunities for tax avoidance. For instance, significantly lowering the corporate tax rate compared to marginal personal income tax rates could encourage business owners and certain high-wage individuals to incorporate and have their income treated as corporate profits. Similarly, the law included a 20 percent deduction for income of pass-through businesses, such as sole proprietorships and partnerships, which could cause taxpayers to change how they file their taxes to lower their tax burdens. Both of these changes could significantly affect state revenues and require more attention from state tax collection agencies.

The Importance of State Conformity

States conform to the federal tax code in a variety of ways, which plays a significant role in how recent changes could affect state revenues. The maps below provide detailed information on conformity status in each state. 

Personal Income Tax: Starting Points

MAP LEGEND

Federal Adjusted Gross Income

Federal Taxable Income

State Gross Income

No Personal Income Tax

*VT- Vermont state income tax calculations will begin at federal AGI rather than federal taxable income starting in tax year 2018.

Source: Federation of Tax Administrators as of January 2017

 

The extent to which states conform to federal definitions of income will have a significant influence over how individual tax code changes affect state revenues. Forty-one states have broad-based individual income taxes and most begin their tax calculations by linking to a federal definition of income. Thirty states and D.C. use federal adjusted gross income (AGI) as a starting point, six begin with federal taxable income, and five use their own state calculation.

Federal AGI is federal gross income minus income adjustments known as “above the line” deductions, which can include IRA contributions, foreign housing costs, moving expenses, and student loan interest payments. Any taxpayer can claim these deductions regardless of whether they itemize. Federal taxable income is federal AGI minus personal exemptions and either the standard deduction or itemized deductions. The Tax Cuts and Jobs Act eliminates, reduces or alters deductible expenses of all kinds, which could mean a broader tax base and more revenue for states that conform.

As the Tax Foundation notes, if there are undesirable revenue impacts from federal tax reform, states have some coping mechanisms available, such as phaseins or tax triggers. States can also look at ways to reform their tax codes in tandem to avoid any undesirable effects, especially since most states have a balanced budget requirement and any revenue changes that result from federal reform will have to be brought in line with spending.

State Personal Income Tax: Conformity to Federal Tax Code

DC PR MP GU AS VI AL AK AZ AR CA CO CT DE FL GA HI ID IL IN IA KS KY LA ME MD MA MI MN MS MO MT NE NV NH NJ NM NY NC ND OH OK OR PA RI SC SD TN TX UT VT VA WA WV WI WY

MAP LEGEND

Rolling Conformity

Static Conformity

No Conformity

Does not Levy Personal Income Tax

*MA- Conforms the the IRC as of Jan. 1, 2015. However, for some provisions, Massachusetts conforms automatically to the Code for the taxable year.
*MS- Mississippi does not have a federal conformity law, but the IRC is incorporated by reference throughout the Mississippi tax code.

Source: Bloomberg BNA, IRC Conformity; Federation of Tax Administrators 2016 State Tax Collection by Source

 

Most state tax codes conform to the federal tax code in terms of how they define income. States conform to the federal tax code to simplify tax administration. Conformity means if something is taxable at the federal level it is taxable at the state level. This also means that if an exemption exists at the federal level, it also exists at the state level. States, however, may “decouple” from specific federal provisions, such as the standard deduction or personal exemption amounts. In fact, every state decouples from the federal code to some extent.

States have two different options in how they conform to the IRC.

Rolling Conformity: The state will automatically conform to the latest version of the IRC. Twenty-two states have rolling conformity for the personal income tax.

Static Conformity: The state must vote to adopt federal changes as they occur. Seventeen states have static conformity for the personal income tax. States with rolling conformity will need to specifically decouple from provisions they do not like, while static conformity states will need to couple to changes they do like.

State Corporate Income Tax: Conformity to Federal Tax Code

DC PR MP GU AS VI AL AK AZ AR CA CO CT DE FL GA HI ID IL IN IA KS KY LA ME MD MA MI MN MS MO MT NE NV* NH NJ NM NY NC ND OH* OK OR* PA RI SC SD TN TX* UT VT VA WA* WV WI WY

MAP LEGEND

Rolling Conformity

Static Conformity

No Conformity

Does not Levy Corporate Income Tax

NV*-Nevada levies a Modified Buisness Tax
OH*- Ohio does not impose a corporate income tax, instead levies a Commerical Activites Tax
OR*-Oregon has a rolling conformity when related to taxable income, but for items other than taxable income, Oregon has a static IRC conformity.
TX*- Texas levies a Margins Tax
WA*- Washington imposes a Business & Occupation Tax

 

Source: Bloomberg BNA, IRC Conformity; Federation of Tax Administrators 2016 State Tax Collection by Source

 

Most state tax codes conform to the federal tax code in terms of how they define income. States conform to the federal tax code primarily to simplify tax administration. Conformity means if something is taxable at the federal level it is taxable at the state level. This also means that if an exemption exists at the federal level, it also exists at the state level. However, states may “decouple” from specific federal provisions, such as the standard deduction or personal exemption amounts. In fact, every state decouples from the federal code to some extent.

States have two different options in how they conform to the IRC.

Rolling Conformity: The state will automatically conform to the latest version of the IRC. Twenty-four states have rolling conformity for the corporate income tax.

Static Conformity: The state must vote to adopt federal changes as they occur.  Eighteen states have static conformity for the corporate income tax. States with rolling conformity will need to specifically decouple from provisions they do not like, while static conformity states will need to couple to changes they do like.

Personal Income Tax

Personal Exemption Elimination

The federal tax bill will repealed personal exemptions through 2025. Ten states currently couple their state personal exemption with the federal personal exemption, which allowed for $4,150 to be deducted for each individual and their dependents. Given that the federal personal exemption was eliminated, these states could see a revenue gain, absent a change in state law. The Joint Committee on Taxation (JCT) estimated that eliminating the personal exemption would increase federal revenues by $1.2 trillion over 10 years, which totals to more than the amount lost by doubling the standard deduction.

Alternative Inflation Measure

The legislation eliminated the use of the traditional CPI-U (consumer price index for all urban consumers) measure for inflationary adjustments to the tax system. Instead, the bill imposed the slower growing, chained CPI measure. The chained CPI removes the substitution bias from the traditional CPI measure by “chaining” two-months together and recognizing that price change also affects purchasing behavior. As a result, the chained CPI shows a slower pace of inflation.

Calculating inflationary adjustments with a slower measure of inflation will affect tax brackets, the standard deduction, the Earned Income Tax Credit (EITC) phasein/phaseout thresholds, and other provisions that are currently adjusted for inflation based on the CPI-U. The Joint Committee on Taxation estimates that this will increase federal revenues by $134 billion over 10 years. Using the chained CPI measure will delay inflationary adjustments and push more income into higher tax brackets, as well as reduce the value of deductions.

Modifications to Other Deductions

The elimination of several deductions could increase revenue for states. Modifications to the deduction for home mortgage interest, nondisaster casualty losses, and moving expenses, among others, have been estimated to increase federal revenues. This would also increase revenues in the states that incorporate these changes.

Standard Deduction

Beginning in 2018, the basic standard deduction nearly doubled to $12,000 and $24,000 for single and married filers, respectively, up from $6,350 and $12,700. The Joint Committee on Taxation estimates that this will reduce federal revenues by $736.9 billion over 10 years.

Twelve states conform to the federal standard deduction. The standard deduction is taken after taxpayers calculate their federal adjusted gross income, but seven states that use federal AGI as their starting point also conform to the federal standard deduction. (Many states have their own standard deductions.) For states that use federal taxable income as their starting points, the increase in the standard deduction will decrease revenues unless actions are taken to decouple. Michigan is the only state the begins with federal taxable income that does not also conform to the federal standard deduction.

Significantly increasing the standard deduction will mean that some people no longer need to itemize. Higher earners will also see a lower federal rate, so the most burdened taxpayers will be the upper-middle class that do not benefit as much from either an increased standard deduction or lower rates.

In 2015, the year for which the latest data is available, $553 billion—44 percent of $1.26 trillion of itemized deductions—were for state and local taxes. Twenty-two percent, ($278 billion) of itemized deductions were for the mortgage interest deduction, and 18 percent ($222 billion) were for the charitable deduction.

Pass-Through Deduction

The new law created a new deduction of 20 percent of qualified business income from certain pass-through entities. The deduction may not exceed 50 percent of the pass-throughs’ employees’ W-2 wages. The threshold at which the wage limit is phased in is $157,000 ($315,000 for joint filers). The conference agreement specifies that the deduction is only allowed in computing and reducing taxable income, not federal AGI, so only the few states that conform to FTI would be affected by this change, which would reduce revenues unless they decouple from this provision or switch to federal AGI as a starting point.

One of criticisms of the Kansas tax reform effort in 2012 is that it eliminated taxes on pass-throughs, which resulted in businesses and employees reclassifying themselves in order to tax advantage of the break. The federal tax bill has guardrails to prevent improper income-shifting and does not come close to eliminating the pass-through tax rate. However, if there is some preferential element for pass-throughs, business entities may try to take advantage of that.

State corporate income tax is already declining rapidly as a revenue source for states, so this could potentially add to that trend with more businesses moving to the individual tax code. Some tax experts have speculated that states may consider eliminating the corporate income tax entirely and look at broader taxes imposed on all forms of business entities, such as Ohio’s commercial activity tax or Texas’ margin tax.

Corporate Income Tax

Deemed Repatriation

Repatriation is the return of money back to a country of origin. This clause levies a mandatory one-time tax on accumulated foreign profits. The plan would tax cash holdings at a rate of 15.5 percent, while earnings held in illiquid assets would be taxed at 8 percent. This would raise revenue for states in the short run as businesses bring back monies held overseas, but tax experts seem divided on whether this will be a small amount or a windfall.

Limitation on Interest Deduction

Every business would be subject to a disallowance of deduction for net interest expenses more than 30 percent of the business’ adjusted taxable income. This may be intended to prevent U.S. business from borrowing substantial amounts to have deductible interest payments count against their income. This measure would raise revenues by reducing profit-shifting.

Net Operating Losses (NOL)

Changes included in the tax bill limiting the NOL deduction could raise revenue in states that conform to federal provisions, or the states that use Federal Taxable Income as the starting point. The NOL deduction would be limited to 80 percent of taxable income and provides that amounts carried to other years be adjusted to account for the limitation for losses arising in tax years beginning after Dec. 31, 2017.

Sixteen states add-back federal NOL, 25 states start with federal taxable income before the NOL deduction. Some states modify the federal NOL. Thirteen states allow NOL carrybacks to the same extent as federal law and 11 states allow NOLs to be carried forward to the same extent as federal law.

Worldwide to Territorial

The TCJA moves the corporate income tax to a territorial system from a worldwide system by exempting foreign income earned by a foreign subsidiary of a U.S. corporation from U.S. tax. Under current law, a corporation headquartered in the U.S. must pay the corporate income tax on all its income, regardless of where it is earned. Corporations can defer the tax on foreign earnings until they are brought back to the U.S. The Joint Committee on Taxation (JCT) estimates that this provision will reduce federal revenues by $215.5 billion over 10 years. States could see a reduction in corporate revenues due to this change, as well. For the District of Columbia and the few states—Alaska, Connecticut, Montana, Rhode Island, Oregon, West Virginia—that have applied worldwide combined reporting to capture corporate income shifted to tax havens, this may increase administrative challenges for a tax that is already difficult to administer.

Temporary Full Expensing

The tax bill allows taxpayers to immediately expense 100 percent of the cost of qualified property acquired and placed into service after Sept. 27, 2017. The amount that may be expensed will be gradually phaseddown over time The JCT estimates this reduce revenues by $63 billion over 10 years. Full-expensing would allow corporations to immediately deduct the cost of any capital expenditures. The goal is to incentivize businesses to invest more and grow the economy, but states that conform would likely see a reduction in revenues in the short term. Most states have already decoupled or modified the existing federal bonus depreciation provisions and, as the Institute on Taxation and Economic Policy has noted, states have not conformed to accelerated depreciation rules in the past; more than 30 states decoupled from a 2002 federal measure allowing companies to immediately write off 30 percent of the cost of eligible investments in the first year.

Furthermore, as tax expert Peter Faber of McDermott, Will and Emory has pointed out, the expensing provision bears a notable relationship to the limitation on interest deductions. If a state adopts temporary full expensing, but not the limitation on interest deductions, businesses could realize a double benefit by purchasing expensed property with borrowed funds and then deducting the interest paid on those loans.

Other Notable Provisions

State and Local Tax Deduction (SALT)

The deduction for state and local income, sales, and property will be retained, but capped at $10,000. The cap is not adjusted to inflation. For the most part, there will be no immediate impact from the repeal of the state and local income tax deduction on state revenues. Most states require taxpayers to add back their state income tax deductions when calculating their itemized deductions for state purposes, which avoids the possibility of allowing a deduction for state income taxes in computing that same tax. A few states—Arizona, Georgia, Hawaii, Louisiana, North Dakota, Ohio—do allow or limit the federal amount of the SALT deduction, but North Dakota is the only one of these states that could see an increase in revenue from the SALT deduction cap, as it uses federal taxable income as its starting point.

The cap on the SALT deduction will raise the effective burden of state income taxes on higher income earners. This could result in a shift of a state’s tax levy mix in the long-term and cause them to move away from income taxation to lessen this burden. New Jersey could potentially delay plans to seek out higher marginal income tax rates in light of the changes to the SALT deduction.

States are pursuing potential workarounds, however, to either effectively preserve the SALT deduction in its entirety or to alleviate possible tax increases for individual taxpayers. For instance, the Tax Cuts and Jobs Act keeps the deduction for charitable contributions. According to the IRS, individuals can give charitable contributions to federal, state, and local governments. Thus, some state and local governments are exploring setting up public purpose funds and providing a credit that nearly or completely offsets state and local taxes. If these public purpose funds were found to meet IRS charitable giving guidelines, donations to these funds would be deductible at the federal level. Many tax experts, however, believe that such a workaround would not withstand a challenge in court. 

Some states have also floated the idea of switching from an income tax, which is levied on employees, to a payroll tax, which is levied on employers and is considered a deductible business expense. Changing who is responsible for the tax could allow states to collect the same amount of tax revenue and could reduce the number of individual taxpayers that would be negatively effected from the $10,000 cap on state and local tax deductibility.

Affordable Care Act Health Insurance Mandate

The TCJA reduces the Affordable Care Act's (ACA) penalty for not obtaining health insurance to $0 beginning in 2019, which effectively repeals the mandate. (In 2018, the penalty for forgoing health insurance will be $695 per adult or 2.5% of household income, whichever is larger.) According to the Congressional Budget Office, repealing the individual mandate would reduce federal budget deficits by around $338 million by 2027. They estimated that the amount of individuals with health insurance would decrease by 4 million in 2019 and 13 million in 2027. CBO also projected that average premiums in the nongroup market would increase by around 10 percent in most years of the decade, not accounting for any changes in the ages of people purchasing insurance. This provision may potentially place an obligation on states to increase healthcare spending in future years. 

Estate Tax

The Tax Cuts and Jobs Act doubles the estate tax exclusion amount from $5.6 million to $11.2 million. Twelve states and the District of Columbia have an estate tax. For the ones that conform to the federal estate tax, doubling the threshold could mean less revenue. For the states that do not, this could create more of an incentive for taxpayers to locate to a state that does not levy one.

Contributions to Capital

The bill provides that the term “contributions to capital,” which are excluded from a corporation’s gross income, does not include contributions by government entities. This means that grants from state and local governments given to businesses as incentives will now be federally taxable. 

Changes to Education Savings

Prior to federal tax reform enacted in 2017, families were only able to use 529 tax-free saving accounts for college expenses. According to The Pew Charitable Trusts 2017 report, “How Governments Support Higher Education Through the Tax Code,” all states that impose an income tax mostly conform to the federal exclusion of 529 plan earnings. Following federal tax reform, these accounts may now also be used for expenses at an "elementary and secondary public, private or religious school." Some states set a maximum deduction or credit for contributions to these plans while others do not set a cap for either. Because of the expansion of eligible expenses, some states may see growing costs, particularly those that do not set a cap on deductions or credits for plan contributions. 

What Did Not Change?

  • Private Activity Bonds: The final bill does not include a House provision to eliminate tax deductibility of private activity bonds, which are used by state and local governments to fund infrastructure projects.
  • Most ACA Taxes: TCJA does not repeal many taxes that from the Affordable Care Act (ACA), such as the Medical Device Tax or the “Cadillac tax” on high-cost insurance plans. Republicans are trying to address these taxes in separate legislation.
  • Retains the student loan deduction, the medical expense deduction and the graduate student tuition waivers.
  • Retirement Accounts: Retirement accounts such as 401(k) plans stay the same.

State Analyses 

States experienced some effects due to the mere possibility of reform, as taxpayers who have the ability to defer income have done so assuming that their taxes will be cut. There are even examples of states that took pre-emptive action in 2017. For example, Oklahoma decoupled from the Internal Revenue Code (IRC) by freezing its standard deduction. At the time, doubling the standard deduction was being considered in congressional tax reform talks and posed a potential loss of revenue for the state, which had been grappling with budget challenges.

Additionally, other states performed analyses of possible revenue changes as a result of federal tax reform. Some state analyses are listed below:

  • Arizona's Joint Legislative Budget Committee published a revenue report looking at the fiscal impact of federal tax conformity. (January 22, 2018)
  • Arkansas Department of Finance and Administration provided a broad overview on the Tax Cuts and Jobs Act. (February 5, 2018)
  • California Franchise Tax Board released a preliminary report on specific provisions of the federal tax law. (March 30, 2018)
  • Colorado:
    • Legislative Council Staff Economists authored a memo on the federal tax legislation that projects increases in income tax revenue beginning FY2018 through at least FY2027. (March 5, 2018)
    • ‚ÄčLegislative Council’s Economic and Budget Outlook projects an increase in state revenue from federal tax reform. (December 2017)
  • Idaho's State Tax Commission released an analysis of the state impact of federal tax reform. (January 19, 2018)
  • Illinois Department of Revenue posted an explanation of the impact on Illinois tax revenue resulting from federal tax reform. (March 1, 2018)
  • Kansas Department of Revenue issued a note in January about federal tax cuts impacting December receipts. (January 2018)
  • Maine Revenue Services' Office of Tax Policy prepared a report on the impacts of the Tax Cuts and Jobs Act on the state. (January 2018)
  • Maryland's Bureau of Revenue Estimates published a report that examines the effects of federal tax reform on the state. (January 25, 2018)
  • Michigan Governor Rick Snyder (R) released a statement regarding the revenue impact due to the Tax Cuts and Jobs Act. (January 8, 2017)
  • The Minnesota Department of Revenue has released a preliminary estimate of the state budget impacts stemming from the passage of the Tax Cuts and Jobs Act. (January 9, 2018)
  • Missouri House Appropriations Analysis: The impact of the standard deduction is a primary concern. It is estimated that the increased standard deduction will decrease Missouri revenues by $516.2 million. Since the value of itemized deductions will decline, more people will take the standard deduction, and the people who continue to itemize will realize a smaller deduction. Therefore, the combined effect will be a reduction in income tax collections of $120 million. (November 2017)
  • Montana DOR estimated revenue changes of major provisions. (Part II) (December 5, 2017)
  • New York:
  • North Carolina detailed the impact of federal tax reform on state revenue in its General Fund Revenue Update. (January 2018)
  • North Dakota’s Tax Commissioner's website on how federal tax reform will impact the state.
  • Oregon Legislative Revenue Office analysis. (March 22, 2017)
  • Pennsylvania released their Mid-Year Update, authored by the Independent Fiscal Office, which discusses impacts of the recent federal changes on the state budget. (January 29, 2018)
  • South Carolina's Revenue and Fiscal Affairs Office published a report estimating the impact of the TCJA and the Bipartisan Budget Act of 2018 on the state. (May 4, 2018)
  • Vermont's Economic Review and Revenue Forecast Update has an appendix (Appendix B) focused on potential state revenue impacts. (January 2018)
  • Virginia Division of Legislative Services authored a legislative issue brief on federal tax reform's impact on the state. (January 2018)
  • Washington's Economic and Revenue Forecast Council presented TCJA's impacts to the state's Senate Ways and Means Committee. (January 18, 2018)
  • Wisconsin's Legislative Fiscal Bureau released a publication on the federal tax law changes enacted in 2017. (February 13, 2018)

Additional Resources