What the Federal Tax Code Reveals About State Revenues

States often adopt the same tax policies as the feds, but should they?
by | February 18, 2016
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Late last year, Congress approved a tax relief package that extended many credits and exemptions. For the sake of consistency, states typically adopt the same credits and exemptions.

But some states choose to be more connected to the federal tax code than others, meaning they have more policy decisions to make when Congress changes its rules.

Take Maine, for example. Lawmakers there are caught in a battle over whether to adopt Congress’ extension of the so-called bonus depreciation, which lets businesses deduct half of their equipment investment in a given tax year, rather than deduct the depreciated value over a period of time. The exemption was enacted for a specific, short-term purpose: to provide an economic stimulus during the recession. But Congress has extended it on a limited basis through 2019. Gov. Paul LePage and other Republicans want the state to follow the feds through 2019, but Democrats want to limit the program and use the savings to give $23 million to schools.

The debate shows that linking to the federal tax code isn’t just about simplicity.

A new Pew Charitable Trusts’ report on tax conformity, released Wednesday, shows that some states are affected more significantly by changes in the federal tax code.

A total of 40 states and the District of Columbia are linked to the federal tax code definitions in at least one of three main ways:

1. Income definitions and exclusions. This means that states might tax regular wages, for example, but exclude a portion of retiree income such as Social Security. Taxpayers can deduct things like home mortgage interest payments and charitable contributions from their taxable income. According to Pew, 37 states and the District do this.

2.  Itemized deductions. A total of 31 states and the District connect to federal itemized deductions, such as high medical expenses, according to Pew.

3. Tax credits. States vary more widely when it comes to which federal tax credits they replicate. Common ones, however, are a child care tax credit and the earned income tax credit (EITC), which offers aid to low-income people as a way to encourage them to work. A total of 26 states and the District link to the EITC, according to the Center on Budget and Policy Priorities.

To test how exposed states are to tax changes at the federal level, Pew researchers ran a hypothetical scenario that broadened the federal tax base by eliminating 42 major personal income tax credits, deductions and exemptions. They also repealed the alternative minimum tax. All this of course increased how much income was subject to the federal taxes, so researchers then reduced federal rates by 40 percent across all tax brackets to maintain revenue neutrality.

They found that at the state level, the scenario had the effect of increasing the amount of income subject to taxation. In general, the more linked a state is to the federal tax code, the more its income tax revenue went up, said Anne Stauffer, the report's author.

Revenue increases varied widely across the states, from less than 5 percent in New Jersey to more than 50 percent in Hawaii, Iowa, Louisiana, Montana, Nebraska and New Mexico. The average increase was 34 percent, translating into roughly $100 billion more in revenue across all the states.

So what are states to take away from this?

When there are federal changes, state policymakers have to decide whether to follow them. If they do accept the federal change, states then have to determine whether they should raise or lower their tax rates to make up the difference in their own revenue.

In Maine, that’s turned into a hot, election year fight that has LePage accusing Democrats in the legislature of holding tax conformity “for ransom” by refusing to enact it without more money for education. “There’s no reason to pay ransom for tax conformity,” said LePage in a recent statement. “If they think tax conformity is good for the Maine people -- which it is -- they should vote for it.”