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Immediate expensing, doubling the standard deduction, and eliminating personal deductions other than mortgage interest and charitable donations have been proposed as part of federal tax reform. In this article, Professor Adam Chodorow of Arizona State University's Sandra Day O'Connor College of Law discusses the impact immediate expensing and other proposed reforms may have on state and local taxation.
By Adam Chodorow
Adam Chodorow is a Professor of Law at the Sandra Day O'Connor College of Law at Arizona State University. He writes on a wide variety of tax topics, ranging from the sublime to the ridiculous. Topics include Biblical taxation, whether those who have died and come back as zombies should be considered dead for estate tax purposes, and a host of other contemporary tax issues, such as the taxation of virtual income.
President Trump released a brief outline of his tax reform proposal last month in which he promised significant tax cuts. Much of the focus has been on the proposed reduction of the nominal tax rates. Less ballyhooed was the proposal to allow immediate expensing of capital purchases, at least during a transition period. Congress has yet to sink its teeth into this proposal, and it is not clear whether expensing will survive that process. Given its support in some quarters, expensing may actually be expanded. Thus, it makes sense to consider both the role capitalization plays in an income tax and how expensing may affect state and local taxation.
At first blush, the capitalization requirements appear to be nothing more than an accounting rule, determining when taxpayers may deduct the cost of assets they acquire. Options include at the time of purchase, when the asset is sold, and over time as depreciation deductions. In fact, the rules requiring capitalization are normative, that is, essential to a true income tax. Purchasing an asset does not count as consumption or lead to a decrease in wealth. Accordingly, no deduction is warranted. Expensing has been sold as a way to simplify the tax code by getting rid of the complicated depreciation rules. In reality, expensing should be seen as a significant tax expenditure that subsidizes asset acquisition. And while it may spur economic growth, as proponents claim, it also puts a thumb on the scale for capital over labor and, as the MIT Economist E. Cary Brown demonstrated 70 years ago, affords consumption tax treatment to asset-intensive businesses.
So what is the likely impact on state and local taxation? For states without income taxes, the answer is not much. Perhaps the economy will get a boost, and they'll see increased revenues from their sales taxes. For states with income taxes, the answer depends on the extent to which state income taxes piggyback on the federal tax rules, also referred to as conformity.
Every income tax includes an income definition, which specifies what is included in income, what deductions are allowed, and when. Most state income taxes start with the federal definition found in the Internal Revenue Code and make small adjustments to reflect state priorities. For instance, in Arizona, which is home to a large number of retirees, taxpayers may deduct all their eligible medical expenses, not simply those that exceed 10 percent of their Adjusted Gross Income.
For states that track the federal rules for treating assets acquisition costs, expensing could spell a significant blow to their revenues. Companies that purchase assets would be allowed to deduct the cost of those assets from their income, in some cases zeroing out their income and eliminating their current tax liability. They don't even need to use their own money to do so. They can simply borrow money to purchase an asset and deduct the cost. The precise impact is unknown, in part because past experiments in bonus depreciation and expensing were for a limited time, on the theory that companies would accelerate their purchases to take advantage of a narrow window. If expensing becomes the norm, part of the incentive effect will be eliminated.
States whose capitalization rules deviate from the federal rules will be spared the effects of expensing on local revenues, but taxpayers in those states will have to keep two sets of books, one reflecting the federal rules, the other reflecting the state rules. Having different bases for state and federal tax purposes will complicate both the record keeping and tax planning, something few taxpayers would relish.
Of course, expensing is not the only change recently proposed. There is talk of doubling the standard deduction, eliminating personal deductions other than the charitable donation and home mortgage deductions. For states that conform to the federal rules, the former could decrease revenues, while the latter could increase them.
Ben Franklin famously remarked that the only thing certain in life is death and taxes. While that may be true, the prospect of significant tax reform, especially in this political moment, introduces significant uncertainty for both taxpayers and state governments about taxes. We can't know what, if anything, will ultimately emerge from this effort, but if anything as dramatic as has been proposed actually passes, states will have the opportunity and perhaps the need to conduct a thorough review of their own tax systems either to take advantage of or protect themselves from changes at the federal level.
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