Executive summary: The state tax policy landscape becomes clearer for 2023
After a near-historic election for state government control, legislators are eager to return to work to address business and individual taxpayer concerns. Income tax cuts steadfastly remain in the discussion, but an uncertain economy may ultimately limit what legislatures can accomplish.
State control for 2023 and tax policy previews
Although a divided government will dominate federal policy discussions, a large majority of the states are able to work with near-perfect uniformity. Following the Nov. 8, 2022 election, control of state government appears to be settled for 2023 with voters guaranteeing 39 state “trifectas” – a term that refers to when the party of both state legislative chambers and the governorship are the same. Republicans can claim 22 trifectas and Democrats 17, leaving a historically low number of states with divided government – 11 states, including Alaska, whose state Senate members have decided to govern by coalition next year. From the executive, 26 Republican governors and 24 Democratic governors will soon, if not already, be issuing budget proposals for the fiscal year 2024 and beyond. While Democrats may have fewer overall trifectas, they can claim seven governorships out of the 11 split-controlled states.
Party control may indicate whether more business-friendly tax policies and tax cuts are proposed versus revenue enhancements. While fewer states are projected to see surpluses like the previous fiscal year, many states will likely end the year in the black. Some states are already considering how to continue taxpayer-friendly policies. For example, Arkansas Governor-elect Sarah Huckabee Sanders discussed phasing out the individual income tax during her campaign following reductions made by the outgoing governor. Mississippi Gov. Tate Reeves has indicated support to fully eliminate the 4% individual income tax rate, recently reduced by 1% in 2022. Montana Gov. Greg Gianforte has stated support to reduce the top income tax rate to 5.9%, although a budget plan has not yet been released. Finally, in an initial budget speech to the legislature, Virginia Gov. Glenn Youngkin proposed lowering the business tax rate from 6% to 4% by the end of his administration and providing similar reductions in the individual income tax rate.
Alternatively, some states may need to look for revenue raisers. Deficits are already estimated in some states, such as California and New York, both of which ended the fiscal year 2022 with surpluses. Federal pandemic funding, low unemployment and consumer spending have helped maintain robust tax revenues around the country. However, plateauing wages, easing hiring and job cuts among some industries are likely to bring down individual income tax collections. The depletion of federal pandemic funding will also begin to weigh on the fiscal year 2024 state budgets. The budget picture is still in the early stages and will likely evolve over the next four to six months as new and experienced governors face potentially declining tax revenues, inflationary concerns and taxpayer accountability. However, slowing revenue collection data suggests that the robust pace of tax cuts may not continue for the third year.
State tax policy and the current political landscape are set to collide in early January as every state legislature will enter session in 2023.
A possibly slowing economy
State finances have been very good coming out of the pandemic, but persistent high inflation, increasing job cuts and continuing global uncertainty may dampen economic prospects in 2023. A recession or even a slowing economy will have negative effects on virtually all state budgets, and whether the economy moves past the current jitters remains to be seen. Assuming we will face a significant economic slowdown, the primary tax impacts will be seen in income and sales tax collections. If that is the case, states will look to add revenue. The question then becomes how.
States are unlikely to increase personal or corporate income taxes in the coming year barring a dramatic financial downturn. In the past two years, two dozen states cut income taxes, reflecting a historic trend—when states have budget surpluses, they are likely to cut income taxes. When states run deficits, they are more likely to increase consumption taxes. This trend has persisted for 40 years. That income taxes are unlikely to be increased is also indicative of greater concerns over inter-jurisdictional competition. Indeed, as noted above, several states are already contemplating income tax cuts in 2023 – seemingly without regard to the economic prospects. Obviously, if the economy sputters, further income tax reductions are unlikely; it is equally unlikely that the states that have already cut income taxes reverse course. If the states need additional revenue, they may turn to broadening their sales tax bases or increasing the growing number of excise taxes in existence. States with narrow sales tax bases can begin taxing more services. Other states may increase alcohol, tobacco or marijuana taxes. Of course, more states may look to legalize online sports gambling or marijuana use to raise additional revenue, two popular areas for tax growth in the last few years.
Other legislative focuses in 2023 may include some or all of the following:
- Adoption or study of combined reporting
- Public Law 86-272 audit enforcement and consideration of the new Multistate Tax Commission guidance
- Expansion or continuation of transfer pricing audits and enforcement
- Pass-through entity tax elections in several remaining states including Indiana, Kentucky and Pennsylvania
- Taxation of the digital economy and cloud-based activity, i.e., sales taxes on digital advertising taxes and digital products and services
- Incentivizing and attracting mobile and remote workers
- Childcare and child tax credits
It will be imperative to follow state tax policy developments both legislatively and administratively. Tax proposals can move quickly in some states, especially with shorter legislative sessions, catching unprepared taxpayers off-guard.
Federal changes may take states by surprise
As is perennially the case, federal tax changes may catch states off guard and out of session, limiting state legislatures’ ability to respond. For the remainder of 2022, not much is left on the table; although, as of the date of this article, government funding is still an open question. Other provisions that may receive year-end attention include capitalization and amortization of research and experimental (R&E) costs under section 174, the requirement to use EBIT (earnings before interest and taxes)—as opposed to EBITA (earnings before interest, taxes, depreciation and amortization)—in the calculation of the interest expense deduction limitation under section 163(j) and the scheduled phase-down in the percentage allowance for bonus depreciation.
For the next session, President Joe Biden must contend with a razor-thin majority in the Senate and an almost as thin Republican majority in the House. Unlike President Donald Trump’s or President Joe Biden’s first two years, a comprehensive tax bill seems less likely than the almost certain political gridlock to come. Perhaps a discussion on conformity to new tax provisions is premature, yet one that should not be completely ignored.
New governors, legislative bodies and state trifectas have already begun to propose and consider tax legislation for 2023 that may increase state and local tax burdens, as revenue forecasts continue to project slowing tax revenue collections compared to the past two fiscal years. Taxpayers should remain flexible, informed and prepared to respond to new tax proposals by comprehensive evaluation and impact modeling. Each of the last three state legislative seasons has brought relatively few tax increases and a surprising amount of taxpayer wins. The pace of tax collection growth as a major revenue driver will almost certainly fall in 2023, but how that will impact state budgets and ultimately state tax policy remains to be seen and may play out in a dynamic and active legislative season. Taxpayers sensitive to tax policy changes, rate increases and sales tax base expansion should consider a plan to respond now and speak to their state tax advisers in preparation for potential tax policy changes