By now, most policymakers are aware that 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. reform can have significant implications for state revenues, leaving states with three options which you might call the Three Rs of Tax Conformity: Retain, Return, or Reform. That is, states anticipating additional revenue due to the base-broadening elements of federal tax reform can retain the increased revenue as an implicit tax increase, return the windfall to taxpayers by decoupling from provisions responsible for the added revenue, or reform their tax codes by adjusting rates and implementing other changes to improve their tax competitiveness while making taxpayers whole.
Some states, however, would prefer not to make that choice just yet, and hope to postpone any action until next year. In states with static (fixed-date) conformity, there’s a common impression that states can delay without consequence by continuing to conform to the old 2017 (or earlier) version of the Internal Revenue Code for another year, thus omitting the revenue-raising adjustments from their own tax codes for now. That’s not entirely true.
There are at least five ways that federal tax reform affect state revenues, and only one is contingent on whether states conform to the newest version of the Internal Revenue Code—though admittedly, it’s an important one. The five sources of new state revenue under the Tax Cuts and Jobs Act are:
- Income starting points for state tax calculations;
- Specific conformity provisions;
- Filing uniformity requirements;
- International income; and
- Dynamic revenue effects.
Most states use adjusted gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” (AGI) as the starting point for state tax calculations, but six use federal 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. . Both starting points correspond to lines on the federal income tax form, and the federal taxable income line includes several major income adjustments which aren’t in AGI, namely standard and itemized deductions and the new pass-through deduction. This is also where personal and dependent exemptions used to be; they’ve now been zeroed out for federal tax purposes.
Consider two states which both conform, on a static basis, to the federal 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 (TCJA) as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. and personal exemption. The first begins with AGI, then selectively conforms to federal deduction and exemption provisions, while the second captures them directly by beginning its calculations with federal taxable income.
The first state can avoid implementing the changes to these provisions by delaying an update to its conformity statute, but the second will capture the changes whether or not it postpones a conformity update, since the federal changes are baked into its starting point. The second state would also capture all changes to itemized deductions. This means that the most consequential base-broadening provisions of the new federal law will flow through to the six states that use federal taxable income regardless of the date specified in their conformity statutes.
Furthermore, many states require that taxpayers use the same filing and itemization status on both their federal and state tax forms. At the federal level, about 30 percent of filers itemized before tax reform, but fewer than 10 percent can be expected to do so now. States which do not permit those claiming the federal standard deduction to itemize on their state returns will see more filers claiming a standard deduction that is likely less generous than what they would have received by itemizing, since the benefits from switching from federal itemization outweigh any losses on state returns. This results in a revenue increase for states and is similarly independent of a state’s choice to conform to the current version of the Internal Revenue Code.
The new federal law makes sweeping changes to the treatment of international income, including a deemed 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. provision which will result in a significant short-term revenue windfall for the federal government as well as for states which tax Subpart F income. The relevant federal change is the deemed repatriation itself, not the definition of repatriated income, so states which tax Subpart F income will capture repatriated income even if they haven’t updated their conformity statutes. (There are, of course, other international provisions of importance to states which are contingent on conformity actions.)
Finally, the new law changes incentive structures and favors additional investment. All states, regardless of what they do about tax conformity, will reap the benefits of economic expansion brought about by federal tax reform.
For some states, postponing a conformity update succeeds in delaying the incorporation of much, though not all, of the increased revenue associated with federal tax reform. For others, however, most of the additional revenue will be captured even without updating the state’s tax conformity date. Legislators contemplating tax reform or at least interested in avoiding an unlegislated tax increase would do well to, at a minimum, avoid building any additional revenues into the budget baseline, instead building a surplus that can be swept into a pension or rainy day fund, or returned to taxpayers, rather than being added to the baseline and appropriated.
Because, ultimately, it comes down to the Three Rs: Retain, Return, or Reform. In many states, putting off the decision is tantamount to retaining the money. The absence of a choice is, in fact, a choice of its own.
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