Tax Reform Would Send States Back to ‘Drawing Board’

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By Jennifer McLoughlin

Most modifications materializing from a potential federal tax reform package would throw states’ personal and corporate income tax structures up in the air, according to a leading tax professional.

Any change other than simply lowering tax rates would “make almost every state with a personal and corporate income tax go back to the drawing board on their tax,” Scott Peterson, director of government affairs for Avalara Inc., said during a May 3 panel at the company’s national tax compliance automation conference. Peterson explained that almost no state conforms to any version of tax reform unveiled by federal officials, so tax tweaks will prompt states to assess the effect of tracking the federal changes.

“Anything that changes the definition of one of the terms that the state income taxes are tied to, has the potential of changing that state income tax,” he said in Austin, Texas.

President Donald Trump in late April released a one-page outline highlighting key principles for overhauling the federal tax code. Among the proposals is discarding all itemized deductions for individual taxpayers, with the exception of mortgage interest and charitable contributions—including the popular deduction of certain non-business tax payments to state and local governments.

Should itemized deductions fall victim to future tax reform, the “battle starts all over again six months later in every state legislature,” Peterson said. This potentially poses problems for legislatures not in session next year, such as North Dakota and Texas, if Congress passes tax reform in 2017.

Couple or De-Couple?

Peterson expects that states will decouple from those reforms estimated to cost them money.

“Congress doesn’t have to balance their budget,” he said. However, most states have balanced budget requirements as a matter of law, so that they “can’t be subservient to what Congress does with its tax structure, because it has the potential to negatively affect their taxes.”

“They will automatically start the conversation about decoupling on anything and everything that costs them tax revenue,” Peterson added. “That’s the governor’s job. The governor will have no choice whatsoever. He or she has to propose a balanced budget. And that balanced budget will include not following the federal law on the things that cost them money.”

However, he noted that even with revenue-generating reforms, states also may choose not to couple with the federal code—a provision with a potential positive impact will effectively raise taxes, which is a political challenge. Attempts at a balancing act, in which states follow the federal government’s lead on select exemption cuts but preserve other exemptions, may meet with resistance by lobbyists.

Rate Reduction

Moreover, Peterson explained that the repeal of tax exemptions would broaden the base—increase taxable income—which federal officials could attempt to offset by lowering tax rates.

State legislatures would then have a decision to make with a stronger stream of revenue.

“A broader base at the federal level automatically increases the state base,” Peterson said, adding that “every state legislature is potentially facing serious increases in state and local income tax collections if they do nothing, because your base just got bigger. They have to adjust the rates or convince you that you should pay them more tax than you were paying them before.”

To contact the reporter on this story: Jennifer McLoughlin in Washington at jmcloughlin@bna.com

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

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