Key Findings

  • States incorporate provisions of the federal tax codes into their own codes in varying degrees, meaning that federal tax reform has implications for state revenue beyond any broader economic effects of tax reform.
  • Because the base-broadening provisions of the new federal tax law often flow through to states, while the corresponding rate reductions do not, most states will experience a revenue increase. The vast majority of filers will receive a tax cut at the federal level, but they could easily see a state tax increase unless states act to prevent one.
  • Eighteen states and the District Columbia have “rolling” conformity with the Internal Revenue Code, meaning that they will conform to relevant provisions of the new federal law automatically, while nineteen must update their fixed-date conformity statutes to adopt the new provisions. The remaining states only conform selectively.
  • The largest revenue increases will be in states which conform to the now-repealed federal exemption, either directly or by linking their own personal exemptions to the number of exemptions claimed at the federal level. States which conform to both the standard deduction and the personal exemption will also experience a revenue increase.
  • Six states will incorporate the new 20 percent deduction for pass-through business income unless they decouple from the provision or change their income starting point from federal taxable income to federal adjusted gross income.
  • Unless they act, most states will not conform to an important pro-growth element of federal tax reform, the provision providing for immediate expensing of investments in machinery and equipment. The additional revenue from base broadening elsewhere—including restrictions on interest deductibility—may provide an opportunity to conform to this provision.
  • States which include Subpart F income, a component of income for multinational businesses, in their base may receive a repatriation windfall, but should avoid building this one-time revenue into their budget baseline.
  • States anticipating additional revenue should view this as an opportunity to make their tax codes more competitive. In the past, federal tax reform has initiated a round of state tax reform as well.
  • State fiscal offices have an obligation to provide critical revenue estimate information to legislators during the 2018 legislative sessions.

Table of Contents

Introduction

Each state has its own approach to taxation—its own combination of tax types, rates and structures, and rules and exemptions. These variations reflect a multiplicity of purposes and an array of fiscal aims, some with contemporary urgency and others lost to the ages. Yet even the most iconoclastic state tax structures draw upon the federal tax code, which becomes more pertinent with the federal Tax Cuts and Jobs Act now in effect.

Some states adopt large swaths of the federal tax code by reference; others use it as a starting point, then tinker endlessly; and still others incorporate federal provisions and definitions more sparingly. In some states, the federal tax code is mirrored; in others, echoed. The differences matter greatly, but so do the points of agreement.

States conform to provisions of the federal tax code for a variety of reasons, largely to reduce the compliance burden of state taxation. Doing so allows state administrators and taxpayers alike to rely on federal statutes, rulings, and interpretations, which are generally more detailed and extensive than what any individual state could produce. [1] It provides consistency of definitions for those filing in multiple states, and reduces duplication of effort in filing federal and state taxes. It permits substantial reliance on federal audits and enforcement, along with federal taxpayer data. It helps to curtail tax arbitrage and reduce double taxation. For the filer, it can make things easier by allowing the filer to copy lines directly from their federal tax forms. In the words of one scholar, federal conformity represents a case of “delegating up,” allowing states to conserve legislative, administrative, and judicial resources while reducing taxpayer compliance burdens. [2]

Delegating up, of course, means ceding a certain amount of control, hence the myriad of ways that states modify or decouple from the Internal Revenue Code (IRC). As states enter their legislative sessions following the first overhaul of the federal tax code since 1986, lawmakers are understandably eager to determine what effects these federal changes will have on their own states’ system of taxation—and, perhaps more to the point, on state revenues.

Most states stand to see increased revenue due to federal tax reform, with expansions of the tax base reflected in state tax systems while corresponding rate reductions fail to flow down. The extent to which this is true (and indeed in some cases, whether it is true) depends on the federal tax provisions to which a state conforms. This paper aims to survey some of the more significant federal provisions often incorporated by the states, shedding light on what each state can expect and what options are available to states as they respond to federal tax changes. In the wake of federal tax reform, states have a golden opportunity to move their own tax codes in a more simple, neutral, and pro-growth direction.

State Approaches to Federal Conformity

All states incorporate parts of the federal tax code into their own system of taxation, but how they do so varies widely. In broad terms, however, approaches to IRC conformity can be divided into three classes: rolling, static, and selective. [3]

States with rolling conformity automatically implement federal tax changes as they are enacted, unless the state specifically decouples from a provision. This autopilot approach tends to provide the greatest clarity and predictability for taxpayers, though at a modest cost of state control.

Static (or “fixed date”) conformity also incorporates wholesale updates of the federal tax code, but to the IRC as it existed at a specific point in time, rather than the adopting all changes on a rolling basis. Some such states conform legislatively every year and are functionally identical to states with rolling conformity, albeit with a measure of added uncertainty. Others are inconsistent, and may even conform to an outdated version of the IRC for many years.

Finally, a handful of states only conform selectively, incorporating certain federal provisions or definitions by reference, but omitting large swaths of the federal tax code and forgoing the use of federal definitions of income as their own starting points for calculation.

No state, of course, conforms to every provision of the Internal Revenue Code. Each state offers its own set of modifications, additions, and subtractions to the code. Each adopts its own set of rules and definitions, frequently layered atop those flowing through from the federal code. But from definitions of income to exemptions to net operating losses, and even what filing statuses are available and whether a taxpayer can itemize their deductions, the federal tax code consistently informs state-level taxation.

Federal Tax Changes with State Impacts

In the course of about two hundred pages, the 2017 tax reform bill fundamentally remade significant aspects of the tax code and substantively modified many others. [4] Only some of these changes, however, have the potential to alter state tax systems. Among those which will impact states are:

  • the larger standard deduction (base narrower);
  • the repeal of the personal exemption (base broadener);
  • more generous child tax credits (base narrower);
  • a lower cap on the mortgage interest deduction (base broadener);
  • a temporarily lower threshold for claiming the medical expense deduction (base narrower);
  • repeal of the moving expense and alimony deductions (base broadener);
  • the 20 percent pass-through deduction (base narrower);
  • changes to interest deductibility (base broadener);
  • changes to Section 179 pass-through expensing and bonus depreciation (base narrower);
  • adjustments to net operating loss provisions (base broadener);
  • repeal of Section 199 and modification of other business tax credits (base broadener);
  • a $10,000 state and local tax deduction cap (base broadener);
  • modifications to subpart F income (base narrower);
  • a reduction in the dividends received deduction (base broadener);
  • deemed repatriation (one-time windfall); and
  • the higher estate tax exemption (base narrower).

In aggregate, the base-broadening provisions are worth considerably more than the base-narrowing ones, particularly within the individual income tax code. Each provision changed at the federal level has varying impacts on states, though, and each will be considered in turn. [5] In the tables that follow, provisions where conformity is expected to increase state revenue are indicated with a (+) and those where conformity may result in a loss of revenue are denoted with a (-). As state legislators grapple with what these provisions mean for their state, it is vital that state fiscal offices provide estimates of the effects of each relevant provision.

Individual Income Tax Conformity

State and local individual income taxes account for 23.5 percent of state and local government tax collections nationwide, compared to the 3.7 percent which comes from corporate income taxes. [6] Consequently, even though the 2017 federal tax reform bill made more changes to corporate than personal taxation, the latter are of far greater significance to state government finances.

At the federal level, individuals will receive the benefit of a higher standard deduction, rate cuts (along with broader bracket widths), a more generous child tax credit, and a higher alternative minimum tax (AMT) exemption threshold. To help pay for these changes, the personal exemption has been repealed, the state and local tax deduction is capped at $10,000, the mortgage interest deduction now applies to the first $750,000 of principal value (down from $1 million) and was eliminated for home equity indebtedness in its entirety, and several deductions were eliminated outright. The vast majority of filers will receive a tax cut at the federal level, [7] but because base-broadening measures flow through to many states, while rate reductions do not, they could easily see a state tax increase unless states act to prevent one.

An increase in the standard deduction and the repeal of the personal exemption are easily the most consequential changes for many states, and eliminating the personal exemption broadens the tax base considerably more than raising the standard deduction narrows it. The other changes, although not insubstantial, do not change the fact that for most states, the tax base would be broader after federal tax reform, forcing states to decide whether to keep the additional revenue to grow government, cut rates to avoid an automatic tax increase, or use the broader base to help pay down broader tax reform.

Income Starting Point and Conformity Method

Although each has its own additions and subtractions, twenty-nine states and the District of Columbia use federal adjusted gross income (AGI) as their starting point for calculating individual income tax liability. Another six states (Colorado, Idaho, Minnesota, North Dakota, Oregon, and South Carolina) use federal taxable income. [8] The remaining six states which tax wage income [9] use state-specific definitions of income, although they incorporate some IRC provisions into these definitions.

Figure 1 illustrates how this concept plays out from the perspective of taxpayers on their individual income tax returns. In states which conform to federal AGI, taxpayers carry line 37 from their federal return to their state return. In states which use federal taxable income, taxpayers start by copying line 43, which, as Figure 1 illustrates, includes additional deductions and exemptions, and thus carries with it more provisions from the federal system.

Electing federal taxable income as a starting point for state income taxes has the effect of incorporating federal standard and itemized deductions, the personal exemption, and a new deduction for qualified pass-through business income, unless the state expressly decouples from these provisions. [10] Each of these elements will be considered separately.

Figure 1.

 Income Starting Points on the Federal Form

Eighteen states and the District of Columbia have rolling conformity, nineteen have static conformity, and four only conform selectively without universal reference to a specific version of the IRC. Two states with their own state-defined income starting points nevertheless conform to the IRC: Alabama on a rolling basis and Massachusetts to a fixed year. Most, but not all, static conformity states adopt conforming legislation every year as a matter of course, albeit sometimes retroactively. Massachusetts, however, conforms to the federal tax code as it existed in 2005, and California, Iowa, Kentucky, and Oregon have only brought their federal conformity up to 2015. Figure 2 shows how frequently states update their conformity to federal definitions.

Figure 2.

Individual Income Tax Conformity

Even when static conformity states routinely incorporate updated versions of the federal tax code, the process introduces some measure of uncertainty, and with the recent tax overhaul at the federal level, some states may weigh their options before adopting new IRC conformity legislation. It will, however, be in the best interest of most states to do so, since tax reform broadens the individual income tax base overall.

Sources: State statutes; tax forms; Bloomberg Tax
Table 1. Individual Income Tax Starting Point and Method of Conformity
State Individual Income Starting Point Individual Conformity
Alabama State calculation Rolling
Alaska No tax No tax
Arizona Federal AGI January 1, 2017
Arkansas State calculation Selective
California Federal AGI January 1, 2015
Colorado Federal taxable income Rolling
Connecticut Federal AGI Rolling
Delaware Federal AGI Rolling
Florida No tax No tax
Georgia Federal AGI January 1, 2017
Hawaii Federal AGI December 31, 2016
Idaho Federal taxable income January 1, 2017
Illinois Federal AGI Rolling
Indiana Federal AGI January 1, 2016
Iowa Federal AGI January 1, 2015
Kansas Federal AGI Rolling
Kentucky Federal AGI December 31, 2015
Louisiana Federal AGI Rolling
Maine Federal AGI December 31, 2016
Maryland Federal AGI Rolling
Massachusetts State calculation January 1, 2005
Michigan Federal AGI Rolling
Minnesota Federal taxable income December 16, 2016
Mississippi State calculation Selective
Missouri Federal AGI Rolling
Montana Federal AGI Rolling
Nebraska Federal AGI Rolling
Nevada No tax No tax
New Hampshire Tax on interest & dividends only Tax on interest & dividends only
New Jersey State calculation Selective
New Mexico Federal AGI Rolling
New York Federal AGI Rolling
North Carolina Federal AGI January 1, 2017
North Dakota Federal taxable income Rolling
Ohio Federal AGI March 30, 2017
Oklahoma Federal AGI Rolling
Oregon Federal taxable income December 31, 2016
Pennsylvania State calculation Selective
Rhode Island Federal AGI Rolling
South Carolina Federal taxable income December 31, 2016
South Dakota No tax No tax
Tennessee Tax on interest & dividends only Tax on interest & dividends only
Texas No tax No tax
Utah Federal AGI Rolling
Vermont Federal AGI December 31, 2016
Virginia Federal AGI December 31, 2016
Washington No tax No tax
West Virginia Federal AGI December 31, 2016
Wisconsin Federal AGI December 31, 2016
Wyoming No tax No tax
District of Columbia Federal AGI Rolling

Standard Deduction and Personal Exemption

The new federal law dramatically increases the standard deduction, from $6,500 to $12,000 per single filer (double for joint filers), while repealing the $4,050 per-person personal exemption. These provisions result in the most profound revenue changes in many states.

On federal income tax forms, standard and itemized deductions, and the personal exemption, are below-the-line, meaning that they are claimed after arriving at one’s adjusted gross income (line 37 on Form 1040 for tax year 2016, where AGI is the “line” referenced; see Figure 1), but before arriving at one’s federal taxable income (line 43). Therefore, if a state uses federal taxable income as the starting point for its income tax calculations, then it begins by incorporating filers’ standard (or itemized) deductions and personal exemptions as claimed at the federal level. If a state instead uses federal adjusted gross income as its starting point, then it begins its calculation without the inclusion of these deductions or exemptions.

It is, however, possible for a state which begins with adjusted gross income to expressly incorporate the federal standard deduction, personal exemption, or both, just as it is possible for a state beginning with federal taxable income to disallow them by adding back the value of those adjustments to the filer’s state taxable income. Figure 3 shows how states incorporate the federal standard deduction and personal exemption into their own tax codes.

Eliminating the personal exemption broadens the tax base considerably more than raising the standard deduction narrows it. At the federal level, those changes are paired with a far larger child tax credit, but that provision only flows through to three states, and then only in part.

Figure 3.

The seven states (Colorado, Idaho, Minnesota, New Mexico, North Dakota, South Carolina, and Vermont) that conform on both the standard deduction and personal exemption will experience base broadening, as the standard deduction roughly doubles but the personal exemption is repealed. Missouri, which conforms to the standard deduction but only partially to the personal exemption, [11] could see a revenue loss, while Maine, which conforms to the personal exemption and not the standard deduction, could experience a larger revenue gain. Utah offers credits worth 6 percent of the value of federal deductions and exemptions, and will see a revenue increase due to this proportionality.

Another twelve states offer their own state-defined standard deductions and personal exemptions, but multiply their state-defined personal exemption by the number of exemptions claimed at the federal level. Since the exemption no longer exists at the federal level, this has the practical effect of repealing these states’ personal exemptions unless amended to base the exemptions on the number of dependents claimed, rather than the number of exemptions taken on one’s federal return. [12] Notably, five of these states (California, Hawaii, Oregon, Virginia, and Wisconsin) use static rather than rolling conformity, but would still experience an immediate impact, because the number of exemptions taken on the federal return will be zero without regard to whether a state conforms to the new provisions.

In one of those twelve states, Nebraska, the standard deduction takes the form of the lesser of a state-defined standard deduction or the federal standard deduction. Whereas the federal standard deduction has been the lower of the two since this provision was adopted in 2007, [13] the state-defined deduction is now the lower due to the expanded standard deduction under federal tax reform. Consequently, Nebraska’s standard deduction will rise to the inflation-adjusted level of its own standard deduction (about $6,700 for single filers) rather than mirroring the new federal level ($12,000).

With the exception of Missouri and Nebraska, all states either (1) conform to both the standard deduction and the personal exemption, yielding a broader tax base; (2) conform, in whole or in part, only to the personal exemption, yielding an even broader tax base; or (3) forgo or use both state-defined standard deductions and personal exemptions, leaving the tax base unchanged.

Notes: States which conform to federal taxable income automatically incorporate the federal standard deduction and personal exemption. Nebraska’s standard deduction is the lesser of a state-defined value and the federal standard deduction, and in the aftermath of federal tax reform, the state-defined deduction is the lower of the two. New Hampshire and Tennessee tax interest and dividend income only.
Sources: State statutes; tax forms; Bloomberg Tax
State Standard Deduction (-) Personal Exemption (+)
Table 2. Standard Deduction and Personal Exemption Conformity
Alabama State defined State defined deduction
Alaska No tax No tax
Arizona State defined State defined deduction
Arkansas State defined State defined credit
California State defined Credit linked to federal exemptions claimed
Colorado Conforms to federal Conforms to federal
Connecticut n/a State defined deduction
Delaware State defined Credit linked to federal exemptions claimed
Florida No tax No tax
Georgia State defined State defined deduction
Hawaii State defined Deduction linked to federal exemptions claimed
Idaho Conforms to federal Conforms to federal
Illinois n/a Deduction linked to federal exemptions claimed
Indiana n/a Deduction linked to federal exemptions claimed
Iowa State defined State defined credit
Kansas State defined Deduction linked to federal exemptions claimed
Kentucky State defined State defined credit
Louisiana State defined State defined deduction
Maine State defined Conforms to federal
Maryland State defined Deduction linked to federal exemptions claimed
Massachusetts State defined State defined deduction
Michigan State defined Deduction linked to federal exemptions claimed
Minnesota Conforms to federal Conforms to federal
Mississippi State defined State defined deduction
Missouri Conforms to federal Deduction linked to federal exemptions claimed
Montana State defined State defined deduction
Nebraska State defined Credit linked to federal exemptions claimed
Nevada No tax No tax
New Hampshire No tax No tax
New Jersey n/a State defined
New Mexico Conforms to federal Conforms to federal
New York State defined Deduction linked to federal exemptions claimed
North Carolina State defined n/a
North Dakota Conforms to federal Conforms to federal
Ohio n/a State defined
Oklahoma State defined Deduction linked to federal exemptions claimed
Oregon State defined Credit linked to federal exemptions claimed
Pennsylvania n/a n/a
Rhode Island State defined State defined
South Carolina Conforms to federal Conforms to federal
South Dakota No tax No tax
Tennessee No tax No tax
Texas No tax No tax
Utah Credit worth 6% of federal deduction Credit worth 6% of value of federal exemption
Vermont Conforms to federal Conforms to federal
Virginia State defined Deduction linked to federal exemptions claimed
Washington No tax No tax
West Virginia n/a Deduction linked to federal exemptions claimed
Wisconsin State defined Deduction linked to federal exemptions claimed
Wyoming No tax No tax
District of Columbia State defined State defined deduction

Above-the-Line and Itemized Deductions

Many states incorporate federal tax deductions into their own codes, some of which have been modified or even repealed under the new tax law. Changes to both above-the-line and itemized deductions can have an impact on state revenues.

Above-the-line deductions are those which reduce adjusted gross income. (These are the adjustments made prior to line 37 in Figure 1.) They can be claimed by all filers, regardless of whether they choose to itemize or take the standard deduction. At the federal level, examples of above-the-line deductions have included contributions to Individual Retirement Accounts (IRAs), interest on student loans, higher education expenses, health savings account contributions, moving expenses, and alimony payments, among other deductions.

Below-the-line deductions, by contrast, come after adjusted gross income. They have included the standard deduction and the personal exemption, considered previously, but also itemized deductions, which can only be claimed by filers who do not take the standard deduction. Common itemized deductions include those for state and local taxes, home mortgage interest, medical expenses, and charitable contributions.

The new law repeals the above-the-line deduction for moving expenses (except for active duty military personnel), but also temporarily lowers the eligibility threshold for taking the medical expense deduction. The mortgage interest deduction, which formerly applied to the first $1 million in acquisition value, now applies to $750,000 in acquisition value, though existing mortgages are grandfathered in. Additionally, deductions for home equity indebtedness are no longer allowed.

Even a new $10,000 aggregate cap on state and local tax deductions affects states, even though it is commonly regarded (rightly) as a deduction against state tax liability. This is because many states allow a portion of the deduction (typically that associated with local property taxes) to be claimed, and limit the total size of the state deduction based upon the amount claimed on federal tax returns.

States which begin their calculations with federal taxable income incorporate itemized deductions by default, unless they specifically add back the value of a specific deduction. However, states which begin with adjusted gross income frequently offer these itemized deductions as well. If, in doing so, they tie them to the federal tax code rather than creating them as stand-alone provisions of their own codes, then the new federal changes will affect them as well.

Save for the medical expense deduction, which is now available to a larger number of filers, all these changes are base-broadeners, and will increase revenues for states which conform to these provisions.

Notes: New Hampshire and Tennessee tax interest and dividend income only.
Sources: State statutes; tax forms; Bloomberg Tax
State Moving Expense (+) Mortgage Interest (+) Medical Expense (-) Property Tax (+)
Table 3. Conformity to Above-the-Line and Itemized Deductions
Alabama Yes Yes Yes Yes
Alaska No tax No tax No tax No tax
Arizona Yes Yes No Yes
Arkansas Yes Yes Yes No
California Yes Yes Yes Yes
Colorado No Yes Yes Yes
Connecticut Yes No No No
Delaware Yes Yes Yes Yes
Florida No tax No tax No tax No tax
Georgia No Yes Yes No
Hawaii Yes Yes Yes Yes
Idaho Yes Yes Yes Yes
Illinois Yes No No No
Indiana Yes No No No
Iowa Yes Yes Yes Yes
Kansas No Yes Yes No
Kentucky Yes Yes Yes Yes
Louisiana Yes Yes No No
Maine Yes Yes Yes No
Maryland Yes Yes Yes Yes
Massachusetts No No Yes No
Michigan No No No No
Minnesota Yes Yes Yes Yes
Mississippi Yes Yes Yes Yes
Missouri Yes Yes Yes Yes
Montana Yes Yes Yes Yes
Nebraska Yes Yes Yes No
Nevada No tax No tax No tax No tax
New Hampshire No tax No tax No tax No tax
New Jersey No No Yes No
New Mexico Yes Yes Yes Yes
New York No Yes Yes Yes
North Carolina Yes Yes Yes Yes
North Dakota Yes Yes Yes Yes
Ohio No No No No
Oklahoma Yes Yes Yes Yes
Oregon Yes Yes Yes Yes
Pennsylvania No No No No
Rhode Island Yes No No Yes
South Carolina Yes Yes Yes Yes
South Dakota No tax No tax No tax No tax
Tennessee No tax No tax No tax No tax
Texas No tax No tax No tax No tax
Utah No No No No
Vermont Yes Yes Yes Yes
Virginia Yes Yes Yes Yes
Washington No tax No tax No tax No tax
West Virginia No No No No
Wisconsin No No Yes No
Wyoming No tax No tax No tax No tax
District of Columbia Yes Yes Yes Yes

Child and Family Provisions

Federal tax reform doubled the size of the child tax credit, from $1,000 to $2,000, while dramatically increasing the refundable share, to $1,400. The credit is also available to a much wider range of taxpayers, since income phaseout thresholds rose dramatically. [14] At the federal level, the much larger child tax credit, along with a new $500 per-person family tax credit for dependents not eligible for the child tax credit, more than offsets the loss of the personal exemption for many filers.

Most states, however, do not offer such credits and would not automatically conform to the provision, meaning that they gain (in many cases) from the repeal of the personal exemption without any obligation associated with the expanded child tax credit. However, three states—Colorado, New York, and Oklahoma [15]—offer child tax credits linked to a percentage of the federal credit (for instance, Colorado offers a credit in the amount of 30 percent of the value of the federal credit). The expanded credit would represent a cost to these states if they do not decouple or reduce the percentage at which they match the federal provision.

Thirty-three states offer deductions for contributions to 529 education savings accounts, which may see increased use now that they can be utilized for primary and secondary, as well as higher, education. However, in some states the enabling legislation specifies use for higher education, which may result in a disallowance of state tax benefits to the extent that the accounts are used for primary and secondary education.

Notes: Table indicates whether state offers a deduction for contributions to 529 plans. Some of these plans may not be in compliance with the new federal law permitting withdrawals for K-12 educational spending. New Hampshire and Tennessee tax interest and dividend income only.
Sources: State statutes; tax forms; Bloomberg Tax; Tax Credits for Workers and Their Families
State Child Tax Credits (-) 529 Deduction (-)
Table 4. Child Tax Credit and 529 Plan Conformity
Alabama No Yes
Alaska No tax No tax
Arizona No Yes
Arkansas No Yes
California State defined No
Colorado 30% of federal Yes
Connecticut No Yes
Delaware No No
Florida No tax No tax
Georgia No Yes
Hawaii No Yes
Idaho No Yes
Illinois No Yes
Indiana No No
Iowa No No
Kansas No Yes
Kentucky No No
Louisiana No Yes
Maine No No
Maryland No Yes
Massachusetts No Yes
Michigan No Yes
Minnesota No Yes
Mississippi No Yes
Missouri No Yes
Montana No Yes
Nebraska No Yes
Nevada No tax No tax
New Hampshire No tax No tax
New Jersey No Yes
New Mexico No Yes
New York 33% of federal Yes
North Carolina State defined No
North Dakota No Yes
Ohio No Yes
Oklahoma 5% of federal Yes
Oregon No Yes
Pennsylvania No Yes
Rhode Island No Yes
South Carolina No Yes
South Dakota No tax No tax
Tennessee No tax No tax
Texas No tax No tax
Utah No No
Vermont No No
Virginia No Yes
Washington No tax No tax
West Virginia No Yes
Wisconsin No Yes
Wyoming No tax No tax
District of Columbia No Yes

 

Uniformity Requirements

Federal tax reform will also affect state taxes in more subtle ways, even where state tax codes are unaffected. With a far more generous standard deduction and a curtailment of some itemized deductions, far more taxpayers can be expected to take the standard deduction rather than itemizing on their federal tax return, a decision which affects the taxpayer’s ability to itemize state taxes in some jurisdictions. Before tax reform, about 30 percent of filers itemized. Most now expect fewer than 10 percent of filers to do so under the new law.

If federal changes influence a taxpayer’s choice of filing status (i.e., from married filing jointly to married filing separately or vice versa), this too can constrain choices at the state level, since many require that taxpayers use the same filing status on their federal and state returns.

In some cases, there will be filers who would have been better off taking the standard deduction at the state level but who are forced to itemize because doing so is disproportionately beneficial to them at the federal level, and they are required to follow their federal filing choice on their state return. If these filers now elect to take advantage of the higher federal standard deduction, they would be in a position to use a more personally advantageous choice at the state level, reducing state revenues.

Notes: Not all states offer itemized deductions. Pennsylvania offers neither standard nor itemized deductions. New Hampshire and Tennessee tax interest and dividend income only.
Sources: State statutes; tax forms; Bloomberg Tax
State Filing Status Linkage Itemization Linkage
Table 5. Uniformity Requirements for Federal and State Income Tax Returns
Alabama No No
Alaska No tax No tax
Arizona No No
Arkansas No No
California Yes No
Colorado Yes n/a
Connecticut Yes n/a
Delaware No No
Florida No tax No tax
Georgia Yes Yes
Hawaii No No
Idaho Yes No
Illinois Yes n/a
Indiana Yes n/a
Iowa No No
Kansas Yes Yes
Kentucky No No
Louisiana Yes n/a
Maine Yes Yes
Maryland Yes No
Massachusetts Yes n/a
Michigan Yes n/a
Minnesota Yes No
Mississippi No No
Missouri Yes Yes
Montana No No
Nebraska Yes No
Nevada No tax No tax
New Hampshire No tax No tax
New Jersey Yes n/a
New Mexico Yes Yes
New York Yes Yes
North Carolina Yes Yes
North Dakota Yes n/a
Ohio Yes n/a
Oklahoma Yes Yes
Oregon Yes No
Pennsylvania No n/a
Rhode Island Yes n/a
South Carolina Yes n/a
South Dakota No tax No tax
Tennessee No tax No tax
Texas No tax No tax
Utah Yes No
Vermont Yes n/a
Virginia Yes Yes
Washington No tax No tax
West Virginia Yes n/a
Wisconsin Yes n/a
Wyoming No tax No tax
District of Columbia No Yes

Small Business Expensing and Treatment of Pass-Through Income

With federal tax reform, small businesses will see an expansion of the Section 179 small business expensing provision, which allows certain investments in machinery and equipment to be fully expensed in the year of purchase. This provision will flow through to the states which conform with federal tax treatment.

Under the old law, small businesses could expense up to $500,000 in the year of purchase, with the benefit beginning to phase out above $2 million. The Tax Cuts and Jobs Act raised the expensing cap to $1 million and begins the phaseout at $2.5 million. Thirty-six states adopt federal Section 179 expensing allowances and investment limits, while seven states offer small business expensing regimes with their own expensing limits.

Section 179 applies to businesses on the basis of size, not entity formation, and is thus available to small C corporations as well as pass-through businesses. Because of its phaseout levels, however, it is overwhelmingly utilized by pass-through businesses against individual income tax liability. The full expensing provisions of the new federal law, discussed later, should render Section 179 expensing almost exclusive to pass-through businesses, hence its inclusion in the individual income tax section of this paper. However, because it is not legally limited to such entities, the deduction is available in states which forgo individual but not corporate income taxes.

A new federal provision, the deduction for qualified pass-through business income, will affect a small number of states if they do not decouple proactively. The new provision provides a 20 percent deduction against qualified pass-through business income for those with incomes below $315,000 (if filing jointly). For those above that threshold, the deduction is limited to the greater of (a) 50 percent of wage income or (b) 25 percent of wage income plus 2.5 percent of the cost of tangible depreciable property. Above the threshold, moreover, many professional services firms are excluded. [16]

The Joint Committee on Taxation estimates that the deduction will cost the federal government $414.5 billion over the next ten years, so states which conform to the provision could face a meaningful revenue loss. [17] Consequently, it has understandably emerged as a point of consternation.

A state’s individual income starting point determines whether pass-through businesses will receive the benefit of the deduction at the state as well as the federal level. Crucially, it is structured as a deduction against taxable income, not adjusted gross income. As such, it would be incorporated into the tax codes of Colorado, Idaho, Minnesota, North Dakota, Oregon, [18] and South Carolina, which use federal taxable income as the starting point in determining state tax liability.

Of these, only Colorado and North Dakota conform on a rolling basis; in the other four states, this provision would be picked up only when conformity statutes are updated. If states do not wish to offer the pass-through deduction, they could disallow the deduction expressly by adding back the amount of the deduction into state taxable income, or indirectly by adopting federal AGI as their income starting point.

Figure 4.

Of states which conform to federal AGI or use their own state-defined definition of income, only Montana has the potential to incorporate the pass-through deduction. The state begins with federal AGI, but allows as adjustments to income all “items” contained in Section 161 of the Internal Revenue Code. That section in turn incorporates a wide swath of code which now includes the new pass-through income deduction. The Montana Department of Revenue has concluded that this makes the deduction available in the state, although an independent legislative analysis suggests that the deduction could be disallowed, noting that the state does not fully incorporate every provision that is added to that expansive stretch of federal code. [19]

Notes: Section 179 primarily benefits pass-through businesses, but can be claimed by C corporations as well. The incorporation of the pass-through deduction is disputed in Montana, and to a lesser extent in Oregon. New Hampshire and Tennessee tax interest and dividend income only.
Sources: State statutes; tax forms; Bloomberg Tax
State Section 179 Expensing (-) Pass-Through Deduction (-)
Table 6. Small Business Expensing and Pass-Through Deduction
Alabama Conforms to federal No
Alaska Conforms to federal No individual income tax
Arizona Conforms to federal No
Arkansas State defined No
California State defined No
Colorado Conforms to federal Yes
Connecticut Conforms to federal No
Delaware Conforms to federal No
Florida State defined No individual income tax
Georgia Conforms to federal No
Hawaii State defined No
Idaho Conforms to federal Yes
Illinois Conforms to federal No
Indiana State defined No
Iowa State defined No
Kansas Conforms to federal No
Kentucky Conforms to federal No
Louisiana Conforms to federal No
Maine Conforms to federal No
Maryland Conforms to federal No
Massachusetts Conforms to federal No
Michigan Conforms to federal No
Minnesota Conforms to federal Yes
Mississippi Conforms to federal No
Missouri Conforms to federal No
Montana Conforms to federal Disputed
Nebraska Conforms to federal No
Nevada Gross receipts tax No individual income tax
New Hampshire State defined No individual income tax
New Jersey No No
New Mexico Conforms to federal No
New York Conforms to federal No
North Carolina No No
North Dakota Conforms to federal Yes
Ohio Gross receipts tax No
Oklahoma Conforms to federal No
Oregon Conforms to federal Yes
Pennsylvania Conforms to federal No
Rhode Island Conforms to federal No
South Carolina Conforms to federal Yes
South Dakota No tax No individual income tax
Tennessee Conforms to federal No individual income tax
Texas Conforms to federal No individual income tax
Utah Conforms to federal No
Vermont Conforms to federal No
Virginia Conforms to federal No
Washington Gross receipts tax No individual income tax
West Virginia Conforms to federal No
Wisconsin Conforms to federal No
Wyoming No tax No individual income tax
District of Columbia State defined No

Corporate Tax Conformity

Federal tax reform ushered in a major overhaul of corporate taxation. The new tax law brings the corporate income tax rate in line with the rest of the developed world, overhauls the international taxation regime, changes the tax treatment of capital investment, and modifies or eliminates several targeted tax preferences.

The law modernizes the U.S. tax code by shifting from a worldwide to a territorial tax regime, which is in line with most developed nations. Under a worldwide system, all income, no matter where earned, is subject to domestic taxation, but with credits for taxes paid to other countries. Under a territorial system, a company is only taxed on domestic economic activity. The new U.S. territorial tax system includes a base erosion anti-abuse tax and rules about effectively connected income, designed to counter international tax sheltering or other tax avoidance techniques.

It also allows the full expensing of short-lived capital assets—essentially, investment in machinery and equipment—for five years, after which the provision phases out. The corporate income tax is imposed on net income (after expenses), but traditionally, investment costs must be amortized over many years, following asset depreciation schedules. This creates a bias against investment, and this disparate treatment has long been in the crosshairs of reformers. The new law does not eliminate depreciation schedules altogether, but allows purchases of machinery and equipment to be expensed immediately. This new cost recovery system builds on the prior “bonus depreciation” regime, under which 50 percent of the cost of new machinery and equipment could be expensed in the first year.

At 21 percent, the new corporate income tax rate is now in line with averages for developed nations, while certain deductions, most notably the Section 199 domestic production activities deduction, have been modified or (as in the case of Section 199) repealed. Net operating losses (NOLs) may now be carried forward indefinitely, but carrybacks are disallowed and the amount of losses that can be taken is capped at 80 percent of tax liability in a given year.

While corporate income taxes generally constitute a modest share of state revenue, limiting the impact these changes will have on state coffers, they nonetheless flow through to states in ways worth exploring.

Corporate Income Starting Point and Conformity Method

Forty-five states and the District of Columbia impose corporate income taxes. Of these, sixteen begin their calculations with federal taxable income, while twenty-two adopt federal taxable income before net operating losses and special deductions as their starting point. (Both options represent lines on the federal corporate income tax return.) Alabama, North Carolina, and Vermont use federal taxable income before NOLs but not special deductions.

Louisiana and the District of Columbia begin with federal gross receipts and sales before making a range of adjustments to approach a net figure, while Arkansas and Mississippi implement state-specific calculations. Four states (Nevada, Ohio, Texas, and Washington) use gross receipts taxes in lieu of corporate income taxes, while South Dakota and Wyoming forgo both corporate income and gross receipts taxes.

Twenty-two states and the District of Columbia adopt rolling conformity, implementing changes to the Internal Revenue Code as they are made. Of these, however, Michigan allows taxpayers the choice of rolling conformity or the IRC as it existed on January 1, 2012, while Maryland suspends rolling conformity if—as will happen this year—the state comptroller finds a revenue impact of greater than $5 million.

Twenty-one states use static conformity, and they are more likely to be a couple of years behind on corporate than individual income tax conformity. Arkansas and Mississippi use their own definitions and therefore do not conform. New Jersey also fails to conform, but stipulates that state taxable income is equivalent to federal taxable income before net operations losses and special deductions.

Figure 5.

State tax codes and revenues are influenced by a range of corporate tax changes, including the loss or reform of certain business deductions, modification of the treatment of net operating losses, and the full expensing of machinery and equipment. The latter provision has the potential to outstrip the base broadening associated with the former, but the revenue-positive changes to individual income taxes are far more significant for states’ revenue outlooks. The choice of starting point is chiefly important for the state’s treatment of net operating losses—even though most states adopt their own set of modifications—except for the handful of states which diverge from the norm by using their own state calculation or beginning with gross income.

Sources: State statutes; tax forms; Bloomberg Tax
State Corporate Income Starting Point Corporate Conformity
Table 7. Corporate Income Tax Starting Point and Method of Conformity
Alabama Federal taxable income before NOL Rolling
Alaska Federal taxable income before NOL and special deductions Rolling
Arizona Federal taxable income January 1, 2017
Arkansas State calculation Selective
California Federal taxable income before NOL and special deductions January 1, 2015
Colorado Federal taxable income Rolling
Connecticut Federal taxable income before NOL and special deductions Rolling
Delaware Federal taxable income Rolling
Florida Federal taxable income January 1, 2017
Georgia Federal taxable income January 1, 2017
Hawaii Federal taxable income before NOL and special deductions December 31, 2016
Idaho Federal taxable income January 1, 2017
Illinois Federal taxable income Rolling
Indiana Federal taxable income before NOL and special deductions January 1, 2016
Iowa Federal taxable income before NOL and special deductions January 1, 2015
Kansas Federal taxable income Rolling
Kentucky Federal taxable income before NOL and special deductions December 31, 2015
Louisiana Federal gross receipts and sales Rolling
Maine Federal taxable income December 31, 2016
Maryland Federal taxable income before NOL and special deductions Rolling
Massachusetts Federal taxable income before NOL and special deductions Rolling
Michigan Federal taxable income Rolling
Minnesota Federal taxable income before NOL and special deductions December 31, 2016
Mississippi State calculation Selective
Missouri Federal taxable income Rolling
Montana Federal taxable income before NOL and special deductions Rolling
Nebraska Federal taxable income Rolling
Nevada Gross receipts tax Gross receipts tax
New Hampshire Federal taxable income before NOL and special deductions December 31, 2015
New Jersey Federal taxable income before NOL and special deductions Selective
New Mexico Federal taxable income before NOL and special deductions Rolling
New York Federal taxable income before NOL and special deductions Rolling
North Carolina Federal taxable income before NOL January 1, 2017
North Dakota Federal taxable income Rolling
Ohio Gross receipts tax February 14, 2016
Oklahoma Federal taxable income before NOL and special deductions Rolling
Oregon Federal taxable income before NOL and special deductions December 31, 2016
Pennsylvania Federal taxable income before NOL and special deductions Rolling
Rhode Island Federal taxable income before NOL and special deductions Rolling
South Carolina Federal taxable income December 31, 2016
South Dakota No tax No tax
Tennessee Federal taxable income before NOL and special deductions Rolling
Texas Gross receipts tax January 1, 2007
Utah Federal taxable income before NOL and special deductions Rolling
Vermont Federal taxable income before NOL December 31, 2016
Virginia Federal taxable income December 31, 2016
Washington Gross receipts tax Selective
West Virginia Federal taxable income December 31, 2016
Wisconsin Federal taxable income before NOL and special deductions December 31, 2016
Wyoming No tax No tax
District of Columbia Federal gross receipts and sales Rolling

Treatment of Net Operating Losses

Net operating losses (NOLs) occur when a company’s tax-deductible expenses exceed revenues. Corporate income taxes are intended to fall on net income, but business cycles do not fit neatly into tax years. Absent net operating loss provisions, a corporation which posted a profit in years one and three but took significant losses in year two would not be taxed on its net income over those three years, but rather on the profits of years one and three, without regard to the losses in year two.

To address this problem, the federal tax code permits net operating losses to be carried into other tax years. Under prior law, they could be carried forward up to twenty years and backward up to two years. The new tax law eliminates NOL carrybacks but allows indefinite carryforwards. The amount of losses that can be taken in a given year, however, may not exceed 80 percent of tax liability, ensuring that NOL carryforwards cannot eliminate a company’s tax liability.

Few states conform fully to federal net operating loss provisions. More frequently, states “shadow” federal NOL treatment in a variety of ways, bringing portions of the federal code into state definitions but diverging in various respects.

Fifteen states use a net taxable income starting point, which includes net operating losses. Many of these, however, require that NOLs be added back to taxable income, even if they subsequently offer their own NOL deduction. Separately, many states which use a starting point prior to the NOL deduction subsequently provide their own subtraction from income, representing a state NOL deduction.

Whether states begin their corporate income tax calculations before or after the NOL deduction says less about whether they offer a deduction than about how that deduction conforms to federal provisions. Of significance in the wake of federal tax reform is not the intricacies of each state’s NOL regime, but whether states conform to the number of years that NOLs are permitted to be carried forward and backward, and whether they will incorporate the new caps imposed at the federal level.

A few states conform on years a loss can be carried forward, but disallow carryback losses. Since federal law no longer allows carrybacks, a state is listed as conforming on how long NOLs can be carried so long as it conforms with carryforward provisions, even if statutes require an add-back for carrybacks.

Sources: State statutes; tax forms; Bloomberg Tax
State General Rule Years (-) 80% Cap (+)
Table 8. Treatment of Net Operating Losses
Alabama Modifies years Statutory Federal
Alaska Conforms without modification Federal Federal
Arizona Conforms with year and other modifications Statutory Federal
Arkansas State calculation Statutory Statutory
California Conforms with % and other modifications Federal Statutory
Colorado Conforms with modifications Federal Federal
Connecticut State calculation Statutory Statutory
Delaware Conforms with dollar cap Federal Dollar Cap
Florida Conforms Federal Federal
Georgia State calculation Statutory Statutory
Hawaii Conforms with modifications Federal Federal
Idaho State calculation Statutory Statutory
Illinois State calculation Statutory Statutory
Indiana Adopts federal carryover years Federal Statutory
Iowa Modifies years Statutory Federal
Kansas Conforms with year and other modifications Statutory Federal
Kentucky Conforms with modifications Federal Federal
Louisiana State calculation Statutory Statutory
Maine Conforms with modifications Federal Federal
Maryland Conforms with modifications Federal Federal
Massachusetts State calculation Statutory Statutory
Michigan State calculation Statutory Statutory
Minnesota Conforms with modifications Statutory Federal
Mississippi State calculation Statutory Statutory
Missouri Conforms with modifications Federal Federal
Montana Modifies years Statutory Federal
Nebraska State calculation Statutory Statutory
Nevada Gross receipts tax n/a n/a
New Hampshire Conforms to prior year with modifications Statutory Statutory
New Jersey State calculation Statutory Statutory
New Mexico Conforms with modifications Federal Federal
New York State calculation Statutory Statutory
North Carolina State calculation Statutory Statutory
North Dakota Conforms with modifications Federal Federal
Ohio Gross receipts tax n/a n/a
Oklahoma Conforms with modifications Federal Federal
Oregon State calculation Statutory Statutory
Pennsylvania State calculation Statutory Percentage Cap
Rhode Island Modifies years Statutory Federal
South Carolina Conforms with modifications Federal Federal
South Dakota No tax n/a n/a
Tennessee State calculation Statutory Statutory
Texas Gross receipts tax n/a n/a
Utah State calculation Statutory Statutory
Vermont State calculation Statutory Statutory
Virginia Conforms with modifications Federal Federal
Washington Gross receipts tax n/a n/a
West Virginia Conforms with modifications Federal Federal
Wisconsin State calculation Statutory Statutory
Wyoming No tax n/a n/a
District of Columbia Conforms with modifications Federal Federal

Capital Investment, Interest Deductibility, and Manufacturing Activity

The new federal law’s more favorable treatment of capital investment, described previously, flows through to some states. Federal law now allows purchases of short-lived capital assets (machinery and equipment) to be expensed immediately, rather than depreciated over many years. This replaces the prior bonus depreciation regime, which offered accelerated (but not immediate) depreciation, and the fifteen states which conformed to that cost recovery provision will also conform to the full expensing of machinery and equipment.

Although full expensing reduces state revenue, it is also highly pro-growth, and states would do well to conform to this provision. Accepting this cost should be made easier by the fact that most states can expect a broader overall tax base due to federal tax reform. Within this context, it makes sense to incorporate provisions which drive economic expansion.

Figure 6.

Federal law now restricts the deduction of business interest, limiting the deduction to 30 percent of modified income, with the ability to carry the remainder forward to future tax years. For the first four years, the definition of modified income is earnings before interest, taxes, depreciation, and amortization (EBITDA); afterwards, a more restrictive standard of gross income less depreciation or amortization (EBIT) goes into effect. [20] These changes mean that a greater share of interest costs will be taxable, increasing revenue. Every state except Mississippi conforms to the federal definition of interest expense. Given this change, which increases the cost of investment, states would do well to ensure that they also conform to the new full expensing provision.

The new law also repeals the Section 199 domestic production activities deduction, which provided a deduction worth 9 percent of domestic production gross receipts (or taxable income, if less), meant to advantage domestic manufacturing. Many states, either due to their corporate income starting point or an express linkage, conform to the Section 199 deduction. Its elimination, therefore, represents a broadening of the base for states which have previously offered the preference.

Sources: State statutes; tax forms; Bloomberg Tax
State Full Expensing (-) Interest Limitation (+) Section 199 (+)
Table 9. Conformity on Full Expensing and the Section 199 Deduction
Alabama Yes Yes Yes
Alaska Yes Yes Yes
Arizona No Yes Yes
Arkansas No Yes No
California No Yes No
Colorado Yes Yes Yes
Connecticut No Yes No
Delaware Yes Yes Yes
Florida No Yes Yes
Georgia No Yes No
Hawaii No Yes No
Idaho No Yes Yes
Illinois No Yes No
Indiana No Yes No
Iowa No Yes Yes
Kansas Yes Yes Yes
Kentucky No Yes No
Louisiana Yes Yes Yes
Maine No Yes No
Maryland No Yes No
Massachusetts No Yes No
Michigan No Yes No
Minnesota No Yes No
Mississippi No No No
Missouri Yes Yes Yes
Montana Yes Yes Yes
Nebraska Yes Yes Yes
Nevada Gross receipts tax Yes Gross receipts tax
New Hampshire No Yes No
New Jersey No Yes No
New Mexico Yes Yes Yes
New York No Yes No
North Carolina No Yes No
North Dakota Yes Yes No
Ohio Gross receipts tax Yes Gross receipts tax
Oklahoma Yes Yes Yes
Oregon Yes Yes No
Pennsylvania No Yes Yes
Rhode Island No Yes No
South Carolina No Yes No
South Dakota No tax Yes No tax
Tennessee No Yes No
Texas Gross receipts tax Yes Gross receipts tax
Utah Yes Yes Yes
Vermont No Yes Yes
Virginia No Yes Yes
Washington Gross receipts tax Yes Gross receipts tax
West Virginia Yes Yes Yes
Wisconsin No Yes No
Wyoming No tax Yes No tax
District of Columbia No Yes Yes

International Taxation

The adoption of a more internationally competitive corporate income tax rate and the shift to a territorial tax system will have significant impacts on business decision-making. The immediate state impact of changes to the structure of international taxation, however, depends on states’ treatment of foreign income.

American corporations ended 2017 with about $2.6 trillion in overseas earnings that have not been transferred back into the United States. [21] Under the old “worldwide” system of taxation, U.S. corporations paid the difference between the U.S. statutory corporate income tax of 35 percent and the effective rate in the other nation where the income was earned. However, that liability was deferred so long as the income was not repatriated. As part of the transition to a territorial tax code, these deferred earnings were “deemed” to have been repatriated, meaning they are immediately taxable by the federal government at rates of 15.5 percent on liquid assets and 8.0 percent on illiquid assets. This repatriated income is categorized as Subpart F income.

Whether states include Subpart F income in their tax base dictates whether they will receive additional revenue from income “deemed” repatriated. Since the income was deemed to be repatriated as of the end of calendar year 2017, states which do not tax Subpart F income may be unable to revise their treatment of repatriated income to take advantage of this change. However, even states which decouple from the taxation of Subpart F income may tax the income when it is actually distributed. If distributions to U.S. parent corporations are accelerated, even states which do not tax Subpart F income may stand to benefit. [22]

Deemed repatriation is a one-time event, so states should avoid appropriating the money for recurring expenses or using it to pay down permanent tax relief. Rather than incorporating it into the budget baseline, states might consider depositing any Subpart F windfall in pension funds or rainy day funds, or using it for one-time expenditures.

Shareholders in the United States are now also required to include as income the global intangible low-taxed income (GILTI) of controlled foreign corporations in which they have a stake, treating the income as a deemed dividend. The U.S. parent claims the dividends received deduction of 50 percent at the federal level, meaning that the inclusion is taxed at an effective rate of 10.5 percent (half the new federal corporate income tax rate). This represents a lower deduction percentage, adopted in concert with lower federal rates. Only the lower deduction percentage will flow through to states. Twenty-six states and the District of Columbia conform to the federal dividends received deduction; another nineteen do not.

Sources: State statutes; tax forms; Bloomberg Tax
State Includes Subpart F Income (+) Offers Dividends Received Deduction (-)
Table 10. Subpart F Income and the Dividends Received Deduction
Alabama No Yes
Alaska Yes Yes
Arizona Yes No
Arkansas No No
California No No
Colorado Yes Yes
Connecticut No No
Delaware No No
Florida No No
Georgia No Yes
Hawaii No No
Idaho Yes No
Illinois No Yes
Indiana No Yes
Iowa No Yes
Kansas No Yes
Kentucky No No
Louisiana Yes No
Maine No Yes
Maryland No Yes
Massachusetts No No
Michigan No Yes
Minnesota Yes Yes
Mississippi Yes No
Missouri No Yes
Montana Depends Yes
Nebraska No Yes
Nevada Gross receipts tax Gross receipts tax
New Hampshire Yes Yes
New Jersey No guidance No
New Mexico No Yes
New York Yes No
North Carolina No Yes
North Dakota No No
Ohio Gross receipts tax Gross receipts tax
Oklahoma Yes No
Oregon No No
Pennsylvania No Yes
Rhode Island No Yes
South Carolina No Yes
South Dakota No tax No tax
Tennessee Yes Yes
Texas No Yes
Utah No No
Vermont Yes No
Virginia No Yes
Washington Gross receipts tax Gross receipts tax
West Virginia No Yes
Wisconsin No Yes
Wyoming No tax No tax
District of Columbia No Yes

Estate Tax Conformity

The House version of the Tax Cuts and Jobs Act sought to repeal the federal estate tax, which would have had major implications for all states which still levy estate taxes, as they tend to rely heavily on the tax infrastructure established by the federal government. The conference report, however, doubled the exemption amount (from $5.6 million to $11.2 million) but retained the tax itself. The changes, therefore, only affect the three jurisdictions—Hawaii, Maine, and the District of Columbia—which conform to the federal exemption level.

States Most Affected by Federal Tax Reform

States which conform to the now-repealed personal exemption will see the largest revenue increases under federal tax reform. Maine, which conforms to the personal exemption but applies a state-defined standard deduction, is the largest beneficiary, followed by the seven states (Colorado, Idaho, Minnesota, New Mexico, North Dakota, South Carolina, and Vermont) which conform on both the standard deduction and the personal exemption.

States which offer their own state-defined standard deductions but tie their personal exemptions, even if at state-defined values, to the number of exemptions claimed at the federal level also stand to gain revenue, in some cases considerably. Most states benefit from changes to deductions for mortgage interest and moving expenses, while the twenty-four states and the District of Columbia which could see their local property tax deductions capped at $10,000 would see a further revenue increase.

The six states which use federal taxable income as their income starting point (Colorado, Idaho, Minnesota, North Dakota, Oregon, and South Carolina) are the most likely to experience revenue losses, since these states would incorporate the new pass-through deduction absent legislation to the contrary. Missouri, which will adopt the much-higher federal standard deduction while dropping a relatively modest personal exemption credit, may also be positioned to lose revenue.

States with a strong multinational presence, and which conform to Subpart F, may experience a windfall due to repatriation. Changes to net operating loss treatment and the elimination of the Section 199 deduction will also increase revenues in many states, while the fifteen which will conform to full expensing will see losses on that provision, generally offset by gains elsewhere.

Options for States

Most states can expect additional revenue due to base-broadening provisions of federal tax reform. Although this additional revenue will not match the windfall experienced after tax reform in 1986, when all but one state with an individual income tax conformed the subsequent year, [23] the increases will be substantial for some states, particularly those which conform to the now-repealed federal personal exemption. A few states, chiefly those which begin their individual income tax calculations with federal taxable income rather than federal adjusted gross income, may stand to lose revenue absent changes to their tax codes.

Decouple from the Pass-Through Deduction

States facing a loss of revenue due to the pass-through deduction may wish to decouple from that provision, either by adopting federal AGI as their income starting point or by expressly adding back the new pass-through deduction. A state like Missouri, which conforms on the much-higher standard deduction but not the now-repealed personal exemption, could restore the personal exemption or, if need be, decouple from the higher standard deduction. States anticipating additional revenue, however, have a more interesting set of options.

Couple to New Expensing Rules

If a state is out of compliance with federal expensing provisions, one of the most pro-growth responses to the additional revenue capacity is to conform to federal treatment of Section 168(k), full expensing of machinery and equipment, and to Section 179, small business expensing. These policies eliminate disincentives for investment and growth baked into the tax code, and thus have the highest return. If necessary, conformity could be phased in over time.

Enact Comprehensive State Tax Reform

In the aftermath of the Tax Reform Act of 1986, eighteen states reduced individual income tax rates, twenty-three increased the standard deduction, and twenty-two increased the personal exemption, among other changes. [24] In 2018, anticipated revenue changes will be smaller, but states will still have an opportunity to avoid an unintentional tax increase by adopting individual and corporate income tax cuts. A less desirable option would be to decouple from federal provisions responsible for the additional revenue.

As a far superior consideration, they could view federal tax reform as a golden opportunity to reform their own tax codes. After 1986, nine states (Arizona, Colorado, Kansas, Maine, Minnesota, Nebraska, New York, North Carolina, and West Virginia) overhauled their individual income taxes entirely. [25] A smaller number of states made substantial changes to corporate income taxes. That opportunity exists in 2018 as well.

Lower federal corporate income tax rates will increase the scope of viable investments, and states are necessarily in competition for that investment. Reduced federal tax burdens also increase the relative importance of state taxation. States which act decisively have an opportunity to position themselves favorably, and additional revenue from base broadening grants them some room to maneuver.

Neutrality is an essential goal of tax reform. It represents the understanding that the goal of taxation is to raise revenue, not to engineer particular economic outcomes. Unfortunately, most tax systems fall far short of this goal, picking winners and losers through the tax code by subsidizing certain activities and industry sectors while penalizing others. By favoring some choices over others, tax codes distort economic decision-making to the detriment of economic expansion. Among other things, tax reform involves leveling the playing field.

Doing so is popular with those who lacked access to targeted incentives and other preferences, but unsurprisingly less popular with those who worked the old system effectively. States are sometimes wary of tax reform because officials fear leaving any business or individual worse off—even if their prior liability was solely the result of undesirable tax preferences. An infusion of additional state revenue, like that associated with federal base broadening, offers states a cushion. It allows them to make their tax codes more neutral and pro-growth while ensuring that a broader percentage of taxpayers are held harmless or made better off due to reform. For states contemplating tax reform, 2018 is an optimal year to act.

Use One-Time Revenues Wisely

At the same time, states should be careful to distinguish recurring revenue from one-time windfalls. Deemed repatriation is a one-time event, and any windfall experienced due to international transition rules should not be added to a state’s budget baseline, allocated to recurring expenses, or returned to taxpayers in the form of permanent rate reductions. To the extent that states can anticipate revenue from repatriation, they would do well to deposit any windfall into pension or rainy day funds, or to appropriate it for one-time projects.

Enhance Federal Conformity

The federal tax code is imperfect. That was true before federal tax reform and it remains true today. Nevertheless, there are important advantages to conforming to the current version of the Internal Revenue Code. Doing so offers greater certainty and reduces both administrative and compliance costs. It reduces the likelihood that provisions will work at cross purposes. It cuts down on tax planning.

The argument is not that the federal tax code is, in all particulars, better than what the states could come up with; it is not. Rather, federal conformity is the lodestar because, whatever the flaws of the IRC, it is better than fifty radically different tax codes. States should move in the direction of greater conformity, not less, in the wake of federal tax reform.

Conclusion

Tax reform did not end with the implementation of H.R. 1. It merely shifted from Washington, D.C., to state capitals. While the vast majority of taxpayers will see a reduction in their federal income tax burdens, the opposite could be true for state taxes should legislators fail to act. In limited cases, states may need to decouple from new federal provisions to avoid unanticipated revenue losses, but in a larger number of states, action is necessary to ensure that residents do not experience an accidental tax increase.

States should avoid the temptation to impose a stealth tax increase and instead view these changes as an opportunity to make their tax codes more competitive. At the federal level, tax reform has proven a generational event. At the state level, it need not be—but there is no time like the present to ensure that state tax codes are oriented toward economic growth.


[1] Kirk Stark, “The Federal Role in State Tax Reform,” Virginia Tax Review 30 (2010), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1718606, 423.

[2] Ruth Mason, “Delegating Up: State Conformity with the Federal Tax Base,” Duke Law Journal 62, no. 7 (April 2013), https://scholarship.law.duke.edu/cgi/viewcontent.cgi?article=3382&context=dlj.

[3] Harley T. Duncan, “Relationships Between Federal and State Income Taxes,” Federation of Tax Administrators, April 2005, http://govinfo.library.unt.edu/taxreformpanel/meetings/pdf/incometax_04182005.pdf, 3-4.

[4] An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018 [hereinafter Tax Cuts and Jobs Act], H.R. 1, 115th Cong. (2017).

[5] The $10,000 cap on the state and local tax deduction only has a limited effect on state tax regimes, to the extent that some states allow the portion of the deduction associated with property and other local taxes (while disallowing the state tax share, which would be recursive), but may also have a modest effect on future revenue capacity, as it limits the ability of states and localities to export a portion of their tax burden to taxpayers nationwide. Expanding the allowable utilization of 529 education savings plans, moreover, may result in an increase in deposits, which could affect states with 529 contribution deductions.

[6] U.S. Census Bureau, 2015 Annual Surveys of State and Local Government Finances, https://www.census.gov/govs/local/.

[7] See Tax Foundation, “Preliminary Details and Analysis of the Tax Cuts and Jobs Act,” Dec. 18, 2017, https://taxfoundation.org/final-tax-cuts-and-jobs-act-details-analysis/, finding increases in after-tax income for all income groups; Amir El-Sibaie, “Who Gets a Tax Cut Under the Tax Cuts and Jobs Act?” Tax Foundation, Dec. 19, 2017, https://taxfoundation.org/final-tax-cuts-and-jobs-act-taxpayer-impacts/, calculating liability for sample taxpayers; and Tax Policy Center, “Distributional Analysis of the Conference Agreement for the Tax Cuts and Jobs Act,” Dec. 18, 2017, http://www.taxpolicycenter.org/publications/distributional-analysis-conference-agreement-tax-cuts-and-jobs-act/full, finding that 80.4 percent of taxpayers receive a tax cut and only 4.8 percent experience a tax increase in 2018.

[8] Oregon is often omitted from such lists, as certain additions to the tax code approximate AGI, and the latter is used in some calculations. However, the income starting point is federal taxable income, which is particularly important now due to the new federal pass-through deduction, considered later.

[9] Seven states forgo all individual income taxation, and another two (New Hampshire and Tennessee) only tax interest and dividend income.

[10] The pass-through deduction cannot be seen in Figure 1, as it was not an option on the current tax form. It will, however, be included between what are currently lines 37 (federal AGI) and 43 (federal taxable income).

[11] Missouri has a smaller state-defined personal exemption tied to the number of exemptions claimed at the federal level. Although this will be zeroed out, it is insufficient to offset the higher standard deduction.

[12] This assumes that the personal exemption line is removed from the federal 1040 individual income tax form. Because the personal exemption has been reduced to $0, this is widely assumed, but the line’s elimination has not been confirmed by the Internal Revenue Service. If filers were still able to claim exemptions on his or her federal return—even though this would confer no benefit at the federal level—they would retain the benefit of these states’ personal exemptions.

[13] Neb. Rev. Stat. §77-2716.01(2)(b).

[14] For joint filers, the phaseout begins at $400,000 of household income, up from $111,000.

[15] Tax Credits for Workers and Their Families, “State Tax Credits,” http://www.taxcreditsforworkersandfamilies.org/state-tax-credits/, 2016; state statutes.

[16] The benefit phases out between $315,000 and $415,000 for those ineligible above the threshold.

[17] The Joint Committee on Taxation, “Estimated Budget Effects Of The Conference Agreement For H.R.1, The ‘Tax Cuts And Jobs Act,’” JCX-67-17, Dec. 18, 2017, https://www.jct.gov/publications.html?func=startdown&id=5053.

[18] Oregon begins with federal taxable income but incorporates adjustments which often result in the state being reported as having federal AGI as a starting point. Some have expressed uncertainty as to whether the pass-through deduction will apply in Oregon.

[19] See Montana Legislative Services Division, Memorandum to Majority Leader Thomas, Jan. 11, 2018, https://bloximages.chicago2.vip.townnews.com/billingsgazette.com/content/tncms/assets/v3/editorial/d/31/d3158656-171f-5f8d-a592-b4f40916aaec/5a5953c1edae1.pdf.pdf; and Jessica DeMarois and Tony Zammit, Memorandum of Legal Advice, Montana Department of Revenue, Jan. 4, 2018, https://bloximages.chicago2.vip.townnews.com/billingsgazette.com/content/tncms/assets/v3/editorial/6/22/622ea7b3-c047-5ff2-88fe-bdb067403c87/5a5953c5ad5c7.pdf.pdf.

[20] Stephen Entin, “Conference Report Limits on Interest Deductions,” Tax Foundation, Dec. 17, 2017, https://taxfoundation.org/conference-report-limits-interest-deductions/.

[21] Thomas Barthold, Letter to Reps. Kevin Brady and Richard Neal, Joint Committee on Taxation, Aug. 3, 2016, https://waysandmeans.house.gov/wp-content/uploads/2016/09/20160831-Barthold-Letter-to-BradyNeal.pdf, 3.

[22] Stephen Kranz, Diann Smith, and Mark Nebergall, “State Income Tax Implications of Base Broadening Components of House and Senate Tax Reform Bills,” McDermott Will & Emory, Dec. 4, 2017, https://www.mwe.com/en/thought-leadership/publications/2017/12/state-income-tax-implications-broadening.

[23] Richard Auxier and Frank Sammartino, “The Tax Debate Moves to the States: The Tax Cuts and Jobs Act Creates Many Questions for States that Link to Federal Income Tax Rules,” Tax Policy Center, Jan. 23, 2018, http://www.taxpolicycenter.org/sites/default/files/publication/152171/the_tax_debate_moves_to_the_states_final_0.pdf, 4.

[24] Steven Gold, “Changes in State Government Finances in the 1980s,” National Tax Journal 44, no. 1 (March 1991), https://www.ntanet.org/NTJ/44/1/ntj-v44n01p1-19-changes-state-government-finances.pdf, 7.

[25] Id.

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