States Brace for Tax Action After Congress Health Bill Fails

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By Che Odom

States worry Congress may look more closely at a key income tax deduction, an exemption on municipal bonds and grants to states after the Republican health care replacement bill was withdrawn last week.

House Speaker Paul D. Ryan (R-Wis.) pulled the American Health Care Act before a vote, killing hopes by some congressional Republicans it would free up roughly $337 billion in savings to pay for tax breaks.

Lawmakers now will look elsewhere for the wiggle room. And that may involve state coffers.

“There has been a fairly heightened concern on these issues among states,” Scott Pattison, CEO of the National Governors Association, told Bloomberg BNA. “Congress may move more quickly on this than expected.”

An association of the nation’s governors March 30 asked congressional leaders to consult with them before Congress passes any major budget or tax bills and potentially shifts costs onto states.

The National Governors Association sent a letter to Senate Majority Leader Mitch McConnell (R-Ky.), Minority Leader Chuck Schumer (D-N.Y.), Ryan and House Minority Leader Nancy Pelosi (D-Calif.). The letter was signed by the association chairman, Virginia Gov. Terry McAuliffe (D), and the vice chairman, Nevada Gov. Brian Sandoval (R).

“We strongly request meaningful consultation with states when considering any reduction or elimination of federal funding that will shift cost to states,” the letter said.

Municipal Bonds

A top concern among states has been the federal tax exemption of interest earned from municipal bonds, a popular method among states and local governments for financing the construction of bridges, roads and other public projects.

Local officials worry elimination of the tax-exempt status would make the bonds less attractive to investors.

The exemption is a target every time substantial tax changes are discussed in Congress, Charles Henck, a tax attorney and partner at Ballard Spahr LLP, told Bloomberg BNA.

“It is probably OK and will survive,” he said. “However, predicting what Congress will do in a broad-based tax bill is like picking the Final Four at the start of the NCAA tournament.”

Commerce Secretary Wilbur Ross, prior to joining Trump’s cabinet, criticized the exemption, calling municipal bonds an inefficient way of paying for projects. President Donald Trump, however, reportedly told a group of mayors visiting him in New York in December that he had no plans to end the exemption.

State and Local Deduction

Another top concern is the federal deduction taxpayers take for the taxes they pay to state and local governments. The nation’s governors are in agreement that the deduction should be preserved, Pattison said.

Taxpayers in states with higher income taxes, such as California and New York, benefit most from the deduction. And that could play a role among Republican lawmakers deciding whether to revisit the deduction, Henck said. “This is always poked at,” he said.

The failure to pass the American Health Care Act makes revenue-neutral tax reform harder, Frank Sammartino, senior fellow at the left-leaning Urban Institute’s Tax Policy Center, told Bloomberg BNA.

Ryan and McConnell have said they want tax reform to be revenue-neutral, because a revenue-neutral bill could be passed under budget reconciliation, which allows it to clear the Senate with only 50 votes.

“If the goal remains revenue-neutral tax reform, then revenue-raising measures such as repealing the deduction become more important, but it is possible that revenue-neutrality might be abandoned in favor of just cutting taxes (which has its own set of problems),” he said in an email.

In any case, repealing or limiting the popular deduction would be hard to do politically, Sammartino said.

Cuts to Programs

Arguably the most likely hit to state budgets may come from unfunded mandates and cuts to federal grants to states. Trump has called for deep cuts to various federal agencies, such as the Environmental Protection Agency and the Health and Human Services Department, that provide grants to states, Henck said.

“That’s going to take away from state budgets” if passed by Congress, he said.

States, given the task to carry out federal programs, could be interested in funding arrangements that allow them more flexibility, but they have strong concerns that the federal government may not sufficiently fund programs, Pattison said.

This year, 25 states are facing or have addressed revenue shortfalls. All told, two-thirds of states are facing or have addressed revenue shortfalls this year, next year, or both, according to a new report by the Center on Budget and Policy Priorities.

The report, released March 30, urges states to take steps to brace for federal cuts and other factors that threaten state revenue.

“State budgets are very tight,” said Pattison, adding that states aren’t going to be able to find money to cover whatever costs the federal government doesn’t.

Base Broadening

Some potential good news for states is that individual income tax revenue would likely increase for them if Congress broadens the base as part of any tax changes this year, according to Nicole Kaeding, an economist at the Tax Foundation.

Though federal income tax rates may decrease at the federal level, Congress is likely to widen the field of what is taxable. For states that follow the federal tax code, this could mean they would see more revenue without having to adjust state rates, Kaeding said at an event in Washington March 24.

“Revenue changes from corporate income tax modification is less straightforward,” she said. The magnitude of revenue of the individual income tax changes would likely be larger than any losses from the corporate side, she said.

To contact the reporter on this story: Che Odom at COdom@bna.com

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

For More Information

Text of the NGA letter is at http://src.bna.com/nue.

The Center on Budget and Policy Priorities report is at http://src.bna.com/nvh.

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