Federal Tax Reform Raises Questions, Possible Revenue Changes for States
Learn more about the way federal tax changes affect states in this report.
As the presidential candidates add their voices to the chorus of lawmakers in Washington calling for comprehensive tax reform, policymakers should be mindful that changes to the federal tax code can have complex repercussions for state tax policy and revenue.
States have a great deal at stake when Washington considers changes to tax policy because nearly every state that levies personal income taxes connects in some way to the federal system. Understanding the extent to which state income taxes are connected to the federal system is important for policymakers at both levels of government when evaluating federal revisions or reforms. (Related: What States Have at Stake in Federal Tax Reform Proposals)
Of the 41 states plus the District of Columbia with broad-based personal income taxes, all but one link to the federal tax code by incorporating into their state tax codes a range of federal tax expenditures, such as the exclusion of employer-paid health insurance premiums, deductions for home mortgage interest, and the earned income tax credit. These linkages to federal law, also known as conformity, mean that policy changes at the federal level can have significant effects on states’ tax policies and revenue and will present state policymakers with choices.
To illustrate the extent to which states are connected to and affected by changes to the federal tax code, The Pew Charitable Trusts examined the impact on states’ revenue of eliminating most federal tax expenditures. Under this scenario, most states’ revenue increased and the more connected a state was to federal law, the larger the boost. Specifically, the analysis used a model of federal and state individual tax systems that reflected state conformity as of 2013 for all 50 states and the District. The researchers then constructed a scenario in which 42 of the major federal personal income tax expenditures—which together accounted for about 80 percent of the total projected forgone federal revenue associated with personal income tax expenditures from 2015 through 2024—were eliminated and federal tax rates were reduced to hold total federal revenue constant. (Related: Tax Code Connections)
The study found that these federal changes would increase total state income tax revenue by about 34 percent. However, the size of the revenue increases varied widely across the 40 states plus the District that have linkages, from less than 5 percent to more than 50 percent, reflecting states’ diverse approaches to conformity. Not surprisingly, the study showed a strong relationship between the number and type of federal expenditures to which a state links and the effect of the hypothetical reform on state collections: The more a state’s tax law conforms to federal law, the higher the revenue impact. For example, the 15 states plus the District that connect to nearly all of the federal tax expenditures eliminated in the scenario had revenue increases above 30 percent, while states that linked just to itemized deductions had increases of less than 20 percent.
States are not obligated to link to the federal tax system or to maintain, add, or reduce links in response to federal policy changes; these are choices made by state policymakers. Pew’s analysis showed that the choice to conform to federal policy changes can have significant effects on state revenue. State policymakers would then face additional choices, such as whether to increase spending, lower tax rates, or both when collections go up—as in the hypothetical scenario—or raise rates and cut spending when they decline. Alternatively, state policymakers could choose not to follow federal changes—that is, to “decouple” from the tax code. This carries its own set of implications: Decoupling may make filing more difficult for taxpayers, reduce compliance, or increase the cost of administering state tax systems.
After the last major federal tax overhaul, in 1986, state leaders faced a series of such decisions. The federal reform included a number of changes, and many states projected increased collections as a result of their conformity. They reacted in various ways: Most accepted the bulk of the changes and then faced the choice of what to do with the added revenue. Some simply collected more tax revenue while others offset the increase by reducing tax rates or expanding personal exemptions, standard deductions, or credits. Still other states used the federal reform as an occasion to substantially restructure their own tax systems.
Identifying the depth and breadth of the connections between state and federal tax policy could help inform a range of debates at both levels of government. Federal policymakers should realize that changes to federal policy can affect their states’ revenue, requiring state policymakers to take action. And state leaders need to weigh the trade-offs of linking to federal tax expenditures, given the possible impacts should changes occur.
Get more data and facts from The Pew Charitable Trusts’ fiscal federalism initiative.
Anne Stauffer directs and Mark Robyn is an officer for Pew’s research on fiscal federalism.