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The impact on states of recent federal tax reform is still being considered. In this article, The Pew Charitable Trusts’ Phil Oliff discusses how state policymakers will need to consider the impact from their linkage to the federal tax code, and the limitation on the deduction for state and local taxes.
By Phillip Oliff
Phil Oliff is a senior manager with The Pew Charitable Trusts’ fiscal federalism initiative.
Now that last year’s tax overhaul is the law of the land, its impact is spilling out beyond the nation’s capital to state governments. While the law is certain to affect state finances, the details are complicated and vary by state, and the effect on any given state remains to be seen. To help clarify this tangled set of issues, here are two key considerations for states as they take stock of the new federal tax landscape.
Tax code linkages mean tough choices for most states, but precise revenue effects are still emerging.
For a variety of reasons—including ease of administration, enforcement, and shared policy goals—all 41 states with a broad-based personal income tax link their tax codes, in one way or another, to the federal code. The new tax law changes a range of federal provisions to which states connect their tax codes and could affect the amount of revenue these states collect. This will force most states to make some difficult choices, including whether to remain connected to the federal provisions that have changed and what to do about the revenue gains or losses that result from staying connected.
The impact on states from the federal tax overhaul will vary widely because states differ in the ways their tax codes relate to the federal tax code. While the most common connection for states is to use the federal definition of income to start a state’s tax calculation, states do so in different ways. For example, most states with an income tax use federal adjusted gross income as a starting point for their tax calculation, but a number of states use federal taxable income. The same is true for federal deductions—both itemized and standard—and personal exemptions. Again, states differ in whether they link to these provisions and how they link to them. The nature of a state’s connections to any of these elements could alter that state’s revenue impact under the new tax law.
Complicating things further, the federal changes could push and pull the revenue of various states in opposite directions. For example, previous research by The Pew Charitable Trusts noted that 12 states use the federal standard deduction in their tax code and would lose revenue from its expansion if they maintained this connection after the deduction increases. Conversely, in the absence of policy changes to decouple, the eight states that link to the federal personal exemption—all of which link to the federal standard deduction—would see a revenue increase from the elimination of the exemption.
Ultimately, careful study of the new law and of state-by-state cost estimates will be crucial to understanding exactly how these linkages could potentially affect state revenue under the tax overhaul. States are just beginning to understand what the numbers look like. And even after careful study, it will be difficult to produce precise estimates since predicting taxpayer behavior, the interaction between provisions, and other potential variables in response to the revised tax landscape will be a challenge.
The new cap on the state and local tax deduction could affect claimants from jurisdictions as different as New York and Nebraska.
The new tax law places a $10,000 cap on the amount taxpayers can deduct in state and local taxes. To put that in perspective, Pew’s research shows that in 2015 about 30 percent of U.S. filers claimed the deduction, and those claimants took an average deduction of $12,471. The average deduction per claimant topped the $10,000 limit in 19 states, including not only New York—where 35 percent of filers claimed the deduction and the average claim was over $22,000—but also Nebraska, where 28 percent of filers claimed the deduction and the average amount deducted was just over $11,000. These figures suggest that the impact of the deduction cap may not be confined to a few states or geographic regions. What’s more, some individual filers with state and local tax liabilities above $10,000 will be affected even in states with averages below the cap.
One way that limiting the deduction may have implications for finances in these states is by making state and local taxes more expensive for some taxpayers—which, experts suggest, could affect a state’s tax policy decisions, including the level and mix of taxes it uses to finance spending priorities.
The bottom line is that federal and state finances are interconnected, and the overall impact of the tax law on states is far-reaching and not limited to any one provision. After studying the implications of the federal tax overhaul on their state, policymakers will need to make tough choices about whether to keep their tax system linked to the new federal code, sever the ties, or otherwise take steps to lessen the ripple effect from the changes.
Copyright © 2018 Tax Management Inc. All Rights Reserved.
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