States in Pickle Over Deductions for Federal Taxes

Daily Tax Report: State provides authoritative coverage of state and local tax developments across the 50 U.S. states and the District of Columbia, tracking legislative and regulatory updates,...

By Che Odom

Six states that provide a deduction for federal taxes will look for ways to reduce an increased burden on taxpayers or to spend the extra loot stemming from the new federal tax law.

Taxpayers in Alabama, Iowa, Louisiana, Missouri, Montana, and Oregon can expect higher state tax bills because their federal income taxes will decrease as a result of the 2017 federal tax act (Pub. L. No. 115-97), signed Dec. 22 by President Donald Trump.

With federal tax rates going down, deductions in these states for taxes paid to the federal government also will go down, leading to higher state tax obligations.

All six states also face budget gaps and eliminating the deduction might necessitate changes in other areas of each state’s tax code—so that keeping the deduction unchanged may be the preferred option.

Still, this could be the year for extensive changes to state tax laws, said John Allan, a state tax expert and partner in the Atlanta office of Jones Day. State lawmakers will have to make significant changes to their tax laws to conform with the federal tax code, which the new tax law altered extensively, he told Bloomberg Tax.

“In the wake of federal tax reform, states have a golden opportunity to move their own tax codes in a more simple, neutral, and pro-growth direction,” Jared Walczak, a senior policy analyst with the Center for State Tax Policy at the Tax Foundation, wrote in a paper released Jan. 31.

Taxpayer Relief

Jan Moller, director of the Louisiana Budget Project, told Bloomberg Tax that changes to Louisiana’s tax code are needed, including elimination of the deduction for federal taxes paid, which could raise more than $100 million for the state.

Louisiana Gov. John Bel Edwards (D) and a legislative tax study called for eliminating the deduction last year, but that effort wasn’t successful. Louisiana lawmakers consider tax bills in odd-numbered years, so no changes should be expected until 2019.

Seeking to reform the state’s tax code, Iowa Gov. Kim Reynolds (R) said the 2017 tax act revealed problems with the deduction for federal taxes paid.

“While that might sound like a good thing, right now it’s not,” she said of the federal law during a Jan. 9 speech. “It creates complexity, and worse, it means that when your federal taxes go down, your Iowa taxes go up.”

Iowa lawmakers attempted in vain to repeal the deduction last year, and Alabama has considered repeal efforts as a way of offsetting the revenue loss that would occur if the state repeals its tax on groceries, according to a blog post by Dylan Grundman, senior policy analyst with the left-leaning Institute on Taxation and Economic Policy.

Budget Shortfalls

Meanwhile, revenue officials in all the six states, like most in the U.S., are continuing to evaluate the precise impact of the new federal law. The changes impact states because most conform to provisions of the Internal Revenue Code to make administration for the state and compliance for taxpayers easier.

“We are working hard right now to determine the best possible way to mitigate the fallout of the resulting budget shortfall of $120 million or more,” Oregon Rep. Phil Barnhart (D), chair of the House Revenue Committee, told Bloomberg Tax. “The start of a new legislative session will give us the opportunity to make adjustments.”

Oregon’s legislative session begins Feb. 5. Oregon’s deduction for federal taxes paid—structured as a subtraction—is capped at $6,550 for 2018. Taxpayers can only claim it on income up to $125,000 for single filers and $250,000 for joint filers. That means there’s not much revenue in play, maybe $20 million to $30 million, Chris Allanach, acting legislative revenue officer, told Bloomberg Tax.

Missouri and Montana also limit the deduction, but Alabama, Louisiana, and Iowa allow a dollar-for-dollar deduction for federal taxes paid.

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