Written Testimony to the House Revenue and 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. ation Committee, Idaho Legislature
February 17, 2018
Chairman Collins, Acting Vice Chair Kauffman, and Members of the Committee:
My name is Nicole Kaeding, and I’m an economist and the Director of Special Projects at the Tax Foundation. For those unfamiliar with us, we are a nonpartisan, nonprofit research organization that has monitored fiscal policy at all levels of government since 1937. We have produced the Facts & Figures handbook since 1941, we calculate Tax Freedom Day each year, we produce the State Business Tax Climate Index, and we have a wealth of other data, rankings, and information at our website, www.TaxFoundation.org.
I’m pleased to submit written testimony on House Bill 463 and House Bill 558, which deal with updating Idaho’s conformity to the Internal Revenue Code. These bills are similar in many ways, but differ on Idaho’s treatment of Internal Revenue Code Section 199A, created by the recently passed Tax Cuts and Jobs Act (TCJA). While I take no position on either bill, I do believe that Idaho should not conform to this specific provision of federal statute.
Tax Conformity is Important
The enactment of federal tax reform has far-reaching implications on state tax codes. States such as Idaho rely heavily on the Internal Revenue Code through a process known as conformity or coupling.
Conformity dramatically reduces the compliance costs of state tax collections. Taxpayers can use their federal 1040 as the basis of their state returns. While all states have made modifications to federal 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.” and federal tax income, taxpayers can save time and energy by not duplicating initial calculations. Conformity also reduces the administrative costs for the state itself. It can define terms based on federal statute and use Internal Revenue Service guidance and publications to help interpret the state’s code. Conformity also makes state tax codes more uniform. Definitions, provisions, and tax treatments are similar across states, reducing compliance burdens for multistate filers, such as corporationAn S corporation is a business entity which elects to pass business income and losses through to its shareholders. The shareholders are then responsible for paying individual income taxes on this income. Unlike subchapter C corporations, an S corporation (S corp) is not subject to the corporate income tax (CIT). s.
For these reasons, conformity should be the goal of all states. No two states conform in the same way, but greater conformity should always guide state conversations.[1]
Section 199A
A controversial section of the Tax Cuts and Jobs Act passed in December of 2017 provides an overly generous benefit to pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. es. Starting in the 2018 tax year, pass-through businesses, those that file on the individual side of the tax code, receive a 20 percent deduction against qualified pass-through business income for those with incomes below $315,000 (joint filers). For filers 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, and many service businesses are excluded. (The benefit phases out between $315,000 and $415,000.)
There’s no question that the pass-through deduction is significant. The Joint Committee on Taxation estimates that it will cost $414.5 billion over the next ten years. Equally significant, however, is that it is structured as a deduction against 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. , not adjusted gross income.
Since most states begin their 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. calculations with adjusted gross income, they do not need to worry about this base-narrowing deduction. Idaho, however, is among a select few of states that would include this deduction, without specific legislative action.
The goal of tax reform is greater neutrality, through lower tax rates and broader 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. s. Ideally, the tax code should not bias the decisions of taxpayers in one way or another. This isn’t always possible due to a variety of reasons, but Section 199A counteracts with this ideal.
The deduction is a carveout with few economic benefits. Pass-through businesses already have a tax advantage within the tax code, compared to traditional C corporations. C corporations are subject to two layers of tax, at the entity and the owner level, while pass-through businesses are only subject to one level of taxation.[2] There is little justification for providing pass-through businesses this generous deduction.
The Revenue Impacts of Conformity
Idaho’s State Tax Commission has released an analysis of the revenue impacts of federal tax reform on the state’s budget.[3] In total, the state estimates an increase of $97.4 million in revenue in fiscal year 2019 from federal tax reform; however, Section 199A conformity would reduce Idaho revenues by $30.8 million.
Decoupling from this base-narrowing provision is good tax policy, but also protects Idaho’s tax base. By decoupling, the state would have an additional $30.8 million in revenue (bringing the total increase from federal tax reform to $128.2 million) to use for more beneficial tax reforms. The additional revenue for Idaho provides the opportunity to cut tax rates, or better yet, adopt meaningful tax reforms. Idaho should also explore coupling to the more pro-growth provisions of the Tax Cuts and Jobs Act, such as the adoption of 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. .
Other State Reactions to Section 199A
As mentioned, Idaho is among a small group of states that conform to Section 199A, due to the state’s close tie to federal taxable income. Other states include Colorado, Minnesota, North Dakota, Oregon, and South Carolina. Discussions in those states have begun as well on how to handle this base-broadening provision.
Oregon’s conversation is the most advanced. Oregon Senate Bill 1528 specifically decouples from Section 199A. It was approved by the Oregon Senate Finance committee on February 9, 2018, and has been referred to the Oregon Senate for approval. As currently drafted, the bill requires Oregon filers to add back any deduction received under Section 199A(a) and applies to all tax years, beginning January 1, 2018.[4]
Conclusion
The federal Tax Cuts and Jobs Act has shifted the tax debate from Washington, D.C., to all fifty state capitals. States, such as Idaho, are trying to determine how best to conform to the litany of federal tax changes. Conformity is generally a recommended action for states, but in the context of the federal Section 199A pass-through deduction, Idaho should decouple from this provision. This base-narrowing provision is the opposite of ideal tax policy.
[1] For more information on conformity, its benefits, or other provisions of the Tax Cuts and Jobs Act, please consult the Tax Foundation’s broader resources on the topic. In particular, Jared Walczak, “Tax Reform Moves to the States: State Revenue Implications and Reform Opportunities Following Federal Tax Reform,” January 31, 2018, https://taxfoundation.org/state-conformity-federal-tax-reform/#7.
[2] Scott Greenberg, “Pass-Through Businesses: Data and Policy,” Tax Foundation, January 17, 2017, https://taxfoundation.org/pass-through-businesses-data-and-policy/.
[3] Idaho State Tax Commission, “Federal Tax Reform–Idaho Impact,” January 19, 2018.
[4] Oregon Senate Bill 1528, Section 10, February 9, 2018, https://olis.leg.state.or.us/liz/2018R1/Downloads/MeasureDocument/SB1528/A-Engrossed.
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