What should states do about the new tax law?

January 23rd, 2018 at 4:04 pm

While everybody’s been trying to figure out what the Republican tax plan means for families, paychecks, and the federal budget, there’s another important group of stakeholders that hasn’t gotten enough attention: states. Yes, the capping of the state and local tax deduction (SALT)—one of the bill’s more substantial payfors (it’s expected to raise over $600 billion over the next decade)—got elevated during the debate. But now that the new code is in place, what does it mean for state finances, what are states planning to do about it, and what should they do?

The fact that every state interacts differently with the federal tax code means that there’s no simple answer to this question, but here’s why trying to figure this out is so critical. Those of us concerned about maintaining what we’ve achieved in terms of progressive social policies are focused on at least two things. First, not losing what we’ve got, and second, making further progress at the sub-national level.

The first goal requires fighting it out around the federal budget and in battles over national policies, like health care and taxes. But regarding the second goal, there’s a trap embedded in their tax plan into which we must not fall: shifting the funding of progressive policies to the states, while making it harder for the states to support them.

Whether it’s Medicaid, SNAP (food stamps), education, job training, infrastructure, or any other anti-poverty program or public good, the R’s strategy is to shrink the federal role by making states responsible for the programs. They sell this under the rubric of “block grants,” with the sales job that states can do a better job administering programs. In fact, states already administer such programs on the ground. The block grant is just a code word for a frozen budget. If you don’t believe me, see the TANF block grant, which has been frozen in nominal terms since the mid-1990s.

OK, so I’m onto their plot. What does any of this have to do with the tax plan?

The answer comes from a new paper by two of my CBPP colleagues—Michael Leachman and Michael Mazerov (or, factoring: Michael(Leachman, Mazerov)). Because some states link to the federal code in a way that will raise state revenues, some state policy makers want to cut taxes because they think their state will get a revenue windfall.

Depending on the existing linkages (state to federal), some revenue raisers in the fed code will also raise state revenues. For example, some states have personal exemptions that mimic the federal ones, so the fact that the new fed code gets rid of these exemptions means more revenues to these states. That is, however, as LM point out, a highly regressive revenue raiser.

Other linkages have similar effects, including the reduction in the mortgage interest deduction and the SALT cap, which raises state revenues because state taxpayers that get fewer itemized deductions will have higher taxable incomes.

But just like the overall tax plan loses much more than it collects—i.e., it is deficit financed—LM point out that “roughly 29 states will lose revenue, see no impact, or see modest revenue gains totaling less than 1 percent of general fund revenue…And in many of those states that could see larger revenue boosts, the added revenue would come disproportionately from lower-income families (due to the elimination of the states’ personal exemptions), which would partially reverse states’ substantial progress in recent decades in eliminating income taxes for families in poverty.”

In fact, as the figure reveals, the federal tax cuts for the richest 1 percent of households alone, whose average income is over $2 million, will amount to about $80 billion this year. “Even under generous assumptions, states will net [about] $7.5 billion to $10 billion in new personal income tax revenue this year…roughly one-tenth of the total windfall for the top 1 percent.” [These estimates are by the invaluable tax analysts at ITEP.]

Further tax cuts at the state level would thus be a serious mistake, one that would both compound the dis-equalizing impacts of the federal change, while making it harder for states to support economically vulnerable populations. Instead, states should:

–Decouple from the federal code on personal exemptions, as any revenue gained through that route is too regressive. Similarly, states should consider decoupling on standard deductions (the new fed code doubles them, so this is a revenue loser for states that link to it), the estate tax, and expensing provisions.

–Build up their reserves to a) offset the R’s attempts to shift anti-poverty funding responsibilities to the states, and b) be ready for the next downturn (LM point out that state budgets, while largely recovered, still have balances below where they need to be in this regard).

–Do not enact further tax cuts.

–Consider tax changes that would hold state taxpayers harmless from the SALT cap. A number of these ideas have surfaced in recent weeks, though they’re complex and may invoke “technical and legal challenges.”

–Improve their revenue outlooks by clawing back some of the windfalls the tax plan bestows on the wealthiest households.

Given the pace at which this benighted tax plan was jammed through, there’s considerable uncertainty regarding its impacts. In my own writings, I’ve stressed the incentives for US multinationals to increase their offshore production, leading to revenue losses for both the state and federal coffers. Bevies of tax lawyers are finding new loopholes every day, underscoring my strongly held view that the revenue losses will go well beyond initial estimates.

All of which pushes toward states not doubling down on further tax cuts, nor allowing these changes to undermine their abilities to make up for the loss of federal support for progressive programs. The conservative playbook is to shift funding sources to the states, while cutting states’ abilities to raise such funds off at the knees. It’s an evil plan, and it must be resisted.

Print Friendly, PDF & Email

5 comments in reply to "What should states do about the new tax law?"

  1. Gerald Scorse says:

    “Bevies of tax lawyers are finding new loopholes every day, underscoring my strongly held view that the revenue losses will go well beyond initial estimates.” Absolutely; the numbers will be staggering (especially since the avoidance/evasion will come predominantly, if not exclusively, from those with higher incomes).

    Therefore, again absolutely, [States should] improve their revenue outlooks by clawing back some of the windfalls the tax plan bestows on the wealthiest households.”

  2. kernel says:

    The Conservative Plan is to increase pressure on the States to “race for the bottom”. Though the Tax Cuts were jammed through too fast, it looks like many of the worst aspects were carefully designed. ALEC and the other groups which ghost-write most GOP legislation probably had a lot of this ready to go – including (or especially?) the parts that punish Blue States which prefer progressive taxation & a strong safety net.

  3. dwb says:

    States like California and Maryland (and others) are too dependent on revenues from the top 10%. In MD, only a few hundred (or in CA, a few hundred thousand) tax payers cause enormous swings in revenue due to tax planning (for example, see here: http://www.baltimoresun.com/news/maryland/politics/bs-md-evaporating-revenue-20170124-story.html 300 taxpayers account for 41% of Maryland revenues).

    The fundamental problem is that high net worth individuals are highly mobile and can easily become members of the “183 club” – meaning they buy a house to establish residency in a low tax state like Florida.

    States that do not cut taxes will see a rapid acceleration of movement out of those states by high net worth people, and states rely on these individuals for a large (>40%) of revenue. Incidentally, many of those places are also places with lower cost of labor and real estate, which drive a substantial portion of corporate costs. So dont be surprised when tech companies like Amazon pick low tax low labor cost places for “alternate” headquarters so employees have choices. I have already seen this trend in the financial sector as banks and insurance cos relocate to Charlotte, NC from NYC, a trend I only expect to accelerate – unless NYC and CA make 180 degree turns in their tax and spending policies.

  4. jeff fisher says:

    “Decoupling” adds a lot of work to tax filing. A state income tax system that closely follows the federal one ends up being very simple to file. Copy a few numbers from the 1040 and you are done.

    However, given the way the new federal tax system has expanded differential rates and deductions, states should work those rules. The proposals to allow ‘donations’ in lieu of property taxes over $10k is the simplest form. I would imagine that creative tax experts could come up with ways for states to transform resident income into pass through or capital gains, and take a share of the winnings for the state of course.

    The federal government has given up on the idea that the federal tax system should be equitable across states. If states had any hesitancy to simply set their rules to exploit federal rules it is time to get over it.