Since the election of President Trump, Washington has been buzzing with talk of tax reform. Yet surprisingly little attention has been paid to the effect federal tax reform might have on state tax systems across the country. Because most state, individual, and corporate income tax systems rely heavily on federal rules, definitions, and calculations, what happens with federal tax reform has broad ramifications on state taxation.
Fundamental income tax reform at the federal level, like that being proposed in the House GOP blueprint, could result in significant changes to state tax bases and the methods by which states collect state income taxes. For states to successfully adapt to federal tax reform, it’s important to open the dialogue now. Giving enough time to properly evaluate the problems presented by that proposal could enable states to take advantage of any opportunity to improve their tax systems. If states are forced to rush to action, the result could (and probably would) be chaos.
Conformity to the federal tax code will be a major consideration for state lawmakers. State conformity to the IRC encourages taxpayer compliance by eliminating the need for taxpayers to know the rules and procedures for both a federal system and completely separate state tax systems. State tax departments likewise rely on the federal system for administration of their income taxes. That reliance can be seen in how states conduct audits. When a state audits a corporate income tax return, it is generally focusing on whether the corporation properly apportioned its income across the states in which the corporation does business. The audit may also examine whether a corporation is a member of a unitary group or whether the corporation properly characterized some transactions or income. States don’t spend much energy examining whether the corporation properly determined its federal taxable income (generally the starting point on the state return). That task is left to the IRS, with states assuming they will be notified if IRS auditors have determined that a corporation’s taxable income must be adjusted.
The House GOP blueprint would fundamentally reform the corporate tax system. Broadly, the blueprint proposes a destination-based cash flow tax with a border adjustment. The proposal would lower the corporate tax rate to 20 percent, reduce the number of individual tax brackets to three, allow 100 percent business expensing, and eliminate the deductibility of interest for business. There would also be a 50 percent deduction for capital gains, while the estate and alternative minimum taxes would be completely repealed. Most business credits would be removed from the code (except for the research credit). Businesses would be allowed 100 percent business expensing. The proposal includes a border adjustment, which disallows the deduction for receipts from export and foreign-derived profits.
At the outset, state revenue would likely decline, but because eliminating or reducing tax expenditures broadens the tax base, long-term state revenue could increase. Of course, even an increase in revenue can pose a problem for states. Determining what to do with excess revenue has proven difficult in the past.
But given the uncertainty of working out the details of a destination-based cash flow tax, states may also choose to forgo a corporate income tax altogether and move to a gross receipts tax. Seven states impose some form of gross receipts tax, and many others have considered it. For states, gross receipts taxes are attractive because they collect tax based on receipts, not income. This means the states can collect tax from corporations in good times and bad.
Beyond issues of conformity and general tax administration, there is the ever-present issue of state revenue. State budgets are in poor shape. Nearly nine years later, many states have not yet fully recovered from the Great Recession of 2008. At least 25 are facing budget shortfalls, and according to a report from the Urban Institute, the federal government provides nearly one-third of the revenue for state expenditures. If those funds are reduced or eliminated, states would have the difficult decision of whether to cut or continue some services.