Idaho Tax Reform Bill Advances

Like most states, Idaho anticipates increased revenue under the new federal tax law, which broadens the state’s tax base. States effectively have three options: (1) do nothing and keep the money; (2) decouple or otherwise tinker with their codes to return the windfall to the taxpayers; or (3) conform with the changes while returning the excess to the taxpayers in the form of rate reductions or structural reforms. Idaho is taking the latter (and superior) route.

In January, the Idaho State Tax Commission estimated that conformity with the new tax law would increase state revenue by $97.4 million, due chiefly to the loss of the personal exemption, worth nearly $412 million in increased revenue. Idaho’s standard deduction and personal exemption both conform to federal levels, meaning that the state’s standard deduction will be $12,000 for single filers this year, up from an anticipated $6,500 (cost: $340.5 million), but the personal and dependent exemptions are eliminated (savings: $411.8 million). Restrictions on itemized deductions are projected to yield an additional $55.3 million.

Outside the higher standard deduction, Idaho’s largest revenue loser under tax conformity is the new pass-through deduction. Idaho is one of only six states with tax codes written in such a way as to incorporate the new federal deduction, which, as we’ve argued previously, is nonneutral and offers little economic benefit. Implementing this new tax preference for pass-through businesses will cost Idaho an estimated $30.8 million.

Recognizing that doing nothing would result in an unintended tax increase, Idaho policymakers, following the lead of Gov. Butch Otter (R), appear to be coalescing around House Bill 463, a plan which:

• Adopts a 0.475 percentage point across-the-board individual income tax rate cut;
• Incorporates the new, higher standard deduction;
• Follows the repeal of the personal and dependent exemptions;
• Creates a new $130 per child tax credit to offset the loss of the personal exemption; and
• Reduces the corporate income tax rate by 0.475 percent.

The bill passed the House and reported out of committee in the Senate on a 5-4 vote yesterday.

This plan involves a net tax cut of $104.5 million, as the reforms and rate reductions cost $201.9 million, while the additional revenue anticipated from federal conformity only runs $97.4 million. Not all states will be in a position to adopt a tax cut, but in Idaho, that opportunity exists. These changes would yield an improvement of three places on the corporate tax component of our State Business Tax Climate Index, which measures tax structure, and an improvement of two places on the individual income tax component. The variety of ways that states are likely to respond to federal tax reform makes such projections tenuous, however, because many other states are likely to implement changes as well.

Overall, House Bill 463 would represent an improvement to Idaho’s tax code, as it makes the state’s high tax rates more competitive and avoids an unlegislated tax increase. It could, however, be made even better by decoupling from the pass-through deduction, which confers little economic benefit, and instead conforming, in whole or in part, to a new federal provision called “full expensing,” which removes some of the tax code’s disincentives for domestic investment by allowing the cost of capital investment—like other business costs—to be written down immediately. Unlike the pass-through deduction, full expensing increases tax neutrality—consistent with the idea that the tax code shouldn’t pick winners and losers—and would make the state more competitive.

Tax reform, after all, is at least partly about leveling the playing field. The principle of neutrality represents the understanding that the goal of taxation is to raise revenue, not to engineer particular economic outcomes. 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. That’s something Idaho policymakers appear to recognize.