Temporary Full Expensing: A Quandary for States

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Tax Policy

Federal tax reform may include a move from depreciation to full expensing of business assets. In this article, the Tax Foundation's Nicole Kaeding discusses how full expensing at the federal level might impact the states.

Nicole Kaeding

By Nicole Kaeding

Nicole Kaeding is an economist at the Center for State Tax Policy at the Tax Foundation.

With the release of the “Big Six” framework for tax reform, states are asking an important question: How will our revenues be impacted by federal tax reform? Much of that discussion has focused on the state and local tax deduction, but states should also consider the impact of full expensing on their budgets.

The Big Six framework calls for full expensing (except for structures) on a temporary basis of “at least” five years. While many details are missing, we do have some insights on how this change would impact states. Full expensing would allow corporations to immediately deduct the cost of any capital expenditures, instead of following complex depreciation schedules.

Full expensing accelerates economic growth, as the cost of capital is reduced. Full, permanent expensing could grow the economy by 4 percent over 10 years, raising wages by more than 3 percent and adding up to 750,000 new jobs nationwide. Now, as my colleague Kyle Pomerleau has shown in a recent paper, expensing as envisioned by the Big Six framework is unlikely to deliver as significant of an impact if it's temporary.


The key to understanding how federal tax reform would change state tax codes and revenues is conformity. For reasons of administrative simplicity, states frequently seek to conform many, though rarely all, elements of their tax codes to the federal code. This harmonization of definitions and policies reduces compliance costs for individuals and businesses with liability in multiple states and limits the potential for double taxation of income. No state conforms to the federal code in all respects, and not all provisions of the federal code make for good tax policy. But greater conformity substantially reduces tax complexity and has significant value.

States tend to conform more on the corporate income tax than the individual income tax. Forty-one states use federal taxable income, before or after net operating losses, as their basis of state taxable income.

Ideally, states would fully conform to any federal tax reform that's passed, but states are following the debate closely, with an eye on their budgets. A true tax reform package—with broader bases and lower rates—should help increase state revenues. As the tax base broadens at the federal level, so does it on the state level. While the federal government plans to use the extra revenues from the expanded tax base to lower marginal tax rates for individual and corporate income, states set their rates independently. Without action, state tax revenues could potentially increase overall. If history is a guide, under that scenario, states are likely to conform to any federal tax changes; this was the approach they took after the 1986 reforms.

Moving to full expensing, by itself, would likely decrease state revenues, particularly up front. Deductions for corporations would increase in aggregate as their new investments are immediately deducted, and expanded capital investment occurs. (The same phenomenon is true at the federal level too.)

With previous instances where the federal government has accelerated depreciation rules, states have been hesitant to conform. That's because the changes were not part of comprehensive reform and would have resulted in a net revenue loss for states. Within one year of the 2002 bonus depreciation changes, 30 states had limited or decoupled from those changes.

States Are Quite Cautious

States are quite cautious about conforming to tax changes that limit their revenues. Unlike the federal government, 49 of the 50 states are governed by balanced budget requirements, and they budget over much shorter time frames (typically one or two years) than the 10-year budget window at the federal level. Small losses of revenue can therefore have a larger impact on the states.

However, the move to full expensing is being considered as part of a broader package, limiting the risk for states. Other changes to the individual and corporate tax codes, such as deemed repatriation and the elimination of other deductions, could provide sufficient revenue to offset any potential revenue loss from moving to full expensing.

Regardless of the revenue impacts, states should strive to conform to changes in expensing rules with the upcoming federal tax reform. Full expensing is a pro-growth tax change, which would increase wages and job creation. By not conforming, states would increase the compliance costs for corporations in their states and limit economic growth potential within their borders.

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