Federal Tax Talks Trigger California Conformity Questions

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By Laura Mahoney

California lawmakers following debate in Congress about a federal tax overhaul are bracing themselves for the complex task of deciding whether and when the state would conform.

The Legislature will need at least six months to examine the eventual federal package and adjust to the potentially radical changes, Assembly Revenue and Taxation Committee Chair Sebastian Ridley-Thomas (D) told Bloomberg BNA Feb. 16.

Because California doesn’t automatically conform to federal tax law changes, legislation would be necessary. California generally conforms to most, but not all, federal provisions. The last conformity measure was enacted in 2015, and before that it was 2009.

Ridley-Thomas said he expects that California won’t conform with everything in any federal package and would phase in the changes it does enact to minimize disruption to the economy.

Diverse Economies

California’s diverse economy closely mirrors the national economy, with a large mix of robust industries and sectors, Ridley-Thomas said. Tax policy might be one area where California and its Democratic leaders may find more common ground with Republicans controlling Congress and the White House, he said.

“It’s important to start getting our minds agile on tax reform and how we might embrace it,” he said.

To jumpstart the state discussion, Ridley-Thomas and State Board of Equalization Vice-Chair Diane Harkey (R) hosted a telephone panel discussion Feb. 14 with federal and state tax specialists who raised key questions for California policy makers to consider.

State Tax Deduction

California taxpayers are among the most likely to be stung by a proposed elimination of the federal deduction for state and local tax payments, but the impact might not be as severe as it appears, Edward Kleinbard, a law professor at the University of Southern California, said during the panel discussion.

Californians tend to have higher incomes and significant state and local tax liabilities compared to residents of many other states, making the deduction “quite important to Californians,” he said.

More than 30 percent of federal returns from California taxpayers claim the deduction, with an average claim of $17,100, according to 2014 data compiled by the Tax Policy Center at the Urban Institute and Brookings Institution. Only Connecticut, New Jersey and New York have more claims with higher average amounts.

However, many California income taxpayers already don’t enjoy the full benefit of the deduction because they don’t itemize, they fall under the alternative minimum tax or their high incomes limit their ability to claim many deductions, Kleinbard said.

Lower Income Rates

Californians also would feel more of the benefit of another element of the Republican package than those in states with typically lower wages and incomes: a reduction in the federal income tax rate. That reduction could offset much of the cost of losing the state and local deduction for many taxpayers, although the overall balance would vary from taxpayer to taxpayer, Kleinbard said.

“There are countervailing factors that tend to be ignored,” he told Bloomberg BNA Feb. 15. “It would not surprise me if it had significantly less impact than we think at first glance.”

Still, the backers of the tax overhaul know elimination of the state and local tax deduction would generally hit harder in higher income and higher tax states like California and New York, which are more Democratic, than it would in states where Republicans hold more sway.

“High state tax states tend to be bluer, so it’s easier for Republicans to think it doesn’t hurt their core constituency,” Kleinbard said.

Kleinbard served as chief of staff to the Congress’ Joint Committee on Taxation before joining USC Law School in 2009.

Local Tax Burdens

Republicans with the goal of reducing overall tax burdens and the size of government also expect elimination of the deduction would put pressure on state and local governments to reduce their taxes, Alan Auerbach, professor of law and economics at University of California, Berkeley, told Bloomberg BNA. Auerbach also participated on the panel discussion.

“Taxpayers may not be worse off” without the state and local tax deduction, “but they may be less willing to pay higher tax rates to the states,” he said.

As for California conformity with federal changes, Auerbach said lawmakers should look beyond making a political statement in opposition to the Republican administration and consider what is best for California taxpayers.

Opportunity From Repatriation

Ridley-Thomas said one of his top priorities for the federal revamp is repatriation of corporate profits from overseas, which could mean $100 million to $400 million in one-time revenue for California. That revenue could pay for one-time infrastructure fixes the state needs, he said.

He is also watching for changes to tax benefits for municipal bonds and charitable organizations.

If federal talks on the overhaul stall or fail, California officials may need to tackle tax changes instead, and he would put a priority on simplification of the California tax system.

“That would not be the worst idea for California taxpayers,” he said.

To contact the reporter on this story: Laura Mahoney in Sacramento, Calif., at LMahoney@bna.com

To contact the editor responsible for this story: Ryan C. Tuck at rtuck@bna.com

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