Many state officials are spending the days leading up to Christmas analyzing the federal taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. bill to see how it will impact state revenues. We at the Tax Foundation have been doing a lot of calls and answering a lot of emails on this, and states are generally finding a revenue boost from the bill. Why is that?
State tax systems are directly affected by federal tax changes because nearly all states conform to the federal code in some way. For example, in 36 states, taxpayers start their state income tax form by using the gross income, adjusted gross income, or taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. figure from the federal return. Nine states have no income tax, so that leaves just six states where taxpayers must start from scratch. This conformity—shadowing federal provisions—reduces tax compliance costs and generally makes things easier for everyone involved.
Several provisions of the federal bill affect states that conform to them:
- Standard DeductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. & Personal Exemptions. The federal bill roughly doubles the standard deduction while eliminating personal exemptions. Seven states (Colorado, Idaho, Minnesota, New Mexico, North Dakota, South Carolina, Vermont) and the District of Columbia conform to both provisions, so they should analyze the net impact of both changes. Two states (Nebraska and Oklahoma) conform only to the standard deduction and not the personal exemption and may see a revenue loss. One state (Maine) conforms to the personal exemption and not the standard deduction and may see a larger revenue gain. All states may also see a revenue gain from greater usage of the standard deduction; the federal bill is expected to reduce itemizers considerably, and most taxpayers file the same status for both federal and state tax returns.
- Pass-Through Provisions. The federal bill includes a 20 percent deduction for nonservice business income, subject to income limits. The deduction is based on federal taxable income, so two states (Colorado and North Dakota) would pick up this deduction immediately, and four other states (Michigan, Minnesota, South Carolina, Vermont) would do so when they next update their conformity. No other state would have this provision apply to state taxes without further legislative action. This deduction would likely reduce state revenue significantly, but it is difficult to estimate it precisely. States should therefore be cautious about conforming to this provision.
- Estate taxAn estate tax is imposed on the net value of an individual’s taxable estate, after any exclusions or credits, at the time of death. The tax is paid by the estate itself before assets are distributed to heirs. . The federal bill doubles the estate tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions. level, and three jurisdictions (District of Columbia, Hawaii, Maine) conform at the same level. DC conforms automatically, while Hawaii and Maine would conform when they next update their conformity plan. The doubled exemption would result in somewhat minor revenue losses.
- State and local tax deduction (SALT). The federal bill replaces the existing unlimited deduction with a maximum $10,000 deduction for property plus either income or sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. es. No state allowed taxpayers to deduct SALT from their state taxes, in large part because it would be circular, so the cap will have little impact to state revenues. The direct effect to state revenues is a net gain, in that many taxpayers who currently take SALT will instead take the standard deduction, potentially adding to the state tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. . However, there is an indirect effect in that taxpayers will bear the full cost of state and local taxation, which would be a net tax increase for some high-income taxpayers. Additionally, the federal bill prohibits 2017 prepayment of state income taxes but not local property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. es, so there may be a shift in such payments from 2018 to 2017 by taxpayers seeking to maximize their deduction before it is capped.
- RepatriationTax repatriation is the process by which multinational companies bring overseas earnings back to the home country. Prior to the 2017 Tax Cuts and Jobs Act (TCJA), the U.S. tax code created major disincentives for U.S. companies to repatriate their earnings. Changes from the TCJA eliminate these disincentives. . Both bills impose a one-time tax on repatriation of ~$2.6 trillion of overseas assets. The tax is “deemed” and is paid immediately, not when assets are repatriated as in an earlier repatriation holiday. States will receive a windfall from this, although it will be uneven based on where international companies have state tax liability. We are still researching the state-by-state conformity with Subpart F and foreign tax deductions.
- Expensing. The federal bill allows full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. for a number of years before phasing out, and reduces interest deductibility. States should evaluate the net impacts of these provisions together when deciding conformity.
- Net Operating Losses (NOLs). The federal bill caps NOL carryforwards at 80 percent and repeal carrybacks. Most states “shadow” the old federal NOL rules, following them without necessarily conforming directly to them. Choosing to conform will probably increase revenue overall, although NOLs can vary greatly year by year.
As I noted above, most states have found positive revenue impacts from the federal bill. Maryland Governor Hogan (R) is discussing legislation that would return the state’s windfall to taxpayers in some form, perhaps by targeting high-income taxpayers likely to be paying more due to the SALT cap. For Iowa, federal tax reform may provide revenue that would enable the state to undertake its long-talked-about state tax reform.
One state found an earlier version of the federal tax bill will reduce revenue, however: Montana. Its revenue analysts found a huge drop in individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. revenue from the pass-through deduction and a large drop in revenue by assuming that PAYGO would take effect and reduce the state’s mineral royalties from the federal government. Neither turned out to be accurate assumptions: the pass-through deduction will not apply to Montana under current law (Montana follows federal adjusted gross income, not taxable income) and PAYGO will likely be waived this week, as it always has been. I’m told Montana is working on an updated revenue estimate, and with updated and less gloomy assumptions it will likely show a revenue boost as well.
Indirect effects of the tax bill must also be kept in mind. The federal bill includes repeal of the health-care individual mandate, which experts say will have negative effects on the individual health insurance market. States may feel obliged to help address these negative effects. Conversely, the pro-growth elements of the federal bill (even the center-left Urban-Brookings Tax Policy Center concluded the bill will boost economic growth) will increase state income and sales tax revenues in some indeterminate amount going forward.
We welcome questions from state officials and others on conformity, which we expect will be a main area of focus in 2018.
Correction (12/29/17): This piece was updated to remove Delaware from the estate tax list. Delaware has repealed its estate tax as of January 1, 2018.
Correction (1/5/18): This piece was updated to reflect that the states which conform on the standard deduction but not the personal exemption are Nebraska and Oklahoma.