State-Level Tax Reform May Be Fast Approaching

By Che Odom and Ryan Prete

Many states could make substantial changes to their tax codes in the next year or two as a result of the new federal tax law.

Some will move to secure increases in revenue as a result of base-broadening provisions in the federal law, while others may “give back” to taxpayers.

“There’s a lot of dollars at stake, hundreds of millions of dollars in both directions,” David Brunori, partner at Quarles & Brady LLP, said Jan. 25 during a conference on the new law sponsored by the District of Columbia Bar Taxation Community.

“How states respond will affect how they go about doing things,” he said.

The 2017 federal tax act ( Pub. L. No. 115-97) eliminates or caps income tax deductions for individuals and business, increasing the scope of what may be taxed. Most states conform to some extent to the federal tax code when it comes to what’s taxable.

So while a federal tax bill may go down, a taxpayer’s state tax liability may increase because of the base broadening. States, in many instances, won’t have to take any action to see an increase in tax revenue.

States are evaluating the impact of the new federal law, with some looking for ways to tweak their statutes to increase revenue further. Other states, however, are already talking about ways to put some of the additional revenue back into taxpayers’ hands, said John Allan, a partner at Jones Day. Governors and lawmakers in Illinois, Iowa, Massachusetts, Michigan, Nebraska, and Vermont are among those looking at giving some relief to taxpayers whose bills could increase.

“They are seeing this as an opportunity to reform their tax systems,” Allan said. “Some are saying, ‘Now is the time.’”

Search for ‘Loopholes’

Certain aspects of the new federal law will require state action, according to a report by the Center on Budget and Policy Priorities (CBPP).

Michael Leachman, the center’s director of state fiscal research and co-author of the report, told Bloomberg Tax that changes at the federal level will drive taxpayers to look for creative ways of interpreting state statutes as they search for tax breaks.

“The new law was created in a rushed process, leaving room for error. For example, it’s likely that taxpayers will find loopholes in the new law, which could reduce revenue for local governments,” he said.

For example, some workers could reduce their tax burden by shifting their status to “independent contractor” from “employee” to take advantage of new, lower tax rates for independent contractors organized as pass-through business entities, Leachman said.

Recommendations

To combat uncertainty created by the federal changes, the CBPP report recommended that states:

•  avoid income tax rate cuts;
•  retain state personal and dependent exemptions;
•  decouple from provisions that weaken state revenue systems;
•  consider raising revenue from corporations and the wealthy;
•  consider “workarounds” related to the $10,000 cap on state and local tax deductions; and
•  build up their reserves to prepare for potential cuts in federal support for states and for the next recession.

Loss of federal aid as a result of decreased federal revenue is a big concern for state and local governments, Mayor Steve Adler (D) of Austin, Texas, said during a Center for American Progress event Jan. 25 in Washington.

The new tax law will reportedly add $1.4 trillion to the federal debt, which is of “great concern,” and “communities and beneficial services throughout the country would face the biggest costs,” he said.

The panel of Democratic mayors argued the new tax law will hurt the individuals who most need help. Pittsburgh Mayor Bill Peduto (D) said the federal changes “would hurt those relying on Medicaid and other services necessary for living the most,” and that “those living on the margin would be hit the hardest.”

Another Revenue Raiser

Just how state and local treasuries will fare in the next few years is an open question—as the federal tax law, itself, is still subject to technical corrections from Congress, and states have yet to react.

However, six states—Alabama, Iowa, Louisiana, Missouri, Montana, and Oregon—could see a boost in tax revenue in a rather unique way.

Those states allow taxpayers to take a deduction for taxes paid to the federal government. With most individual and corporate tax bills expected to slide downward at the federal level, taxpayers in those states will have less to take in deductions at the state level, Brunori said.

“This is a huge revenue raiser, hundreds of millions of dollars in those states in new revenue,” he said.

The conference was hosted by Jones Day and co-sponsored by Bloomberg Tax and Tax Analysts.

To contact the reporter on this story: Che Odom at codom@bloombergtax.com and Ryan Prete in Washington at rprete@bloombergtax.com

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

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