States push forward as Congress considers tax reform
INSIGHT ARTICLE |
With anticipation for federal tax reform building well before President Trump was sworn into office, there have been no shortage of news headlines on the subject. And while there has been discussion and publicity around federal reform, to date, Congress has yet to enact any major tax reform, leaving middle-market companies with as many questions today as they had with the uncertainty surrounding the presidential election.
In the midst of all the questions, state governments have been watching and reacting, planning and preparing for how federal tax reform might affect their budgets and their constituents. When the uncertainty around federal reform is paired with state budget shortfalls, it is clear that understanding the implications of your state and local tax footprint is inarguably as important as any pending federal tax reforms.
First, a look at federal reform. Since the election, the GOP-controlled house and the president have issued various proposed targets of reform. More recently, a “unified framework” was released by the president expressing four principals of tax reform: a more simple tax code, increased tax savings for more employees, attracting jobs, and repatriation of offshore dollars. The chart below highlights some of the more specific items the framework seeks to address:
|Individual Reform||Business Reform|
|Individual tax bracket changes||Reduce corporate tax rate|
|Repeal alternative minimum tax (AMT)||Reduce rate for pass-through earnings|
|Increased Child Tax Credit||Allow immediate expensing for capital expenditures|
|Eliminating many deductions||Modernizing industry-specific tax regimes|
|Repeal estate tax||Repatriation of foreign profits|
The timing of reform, negotiation of the proposals, and when the first legislative drafts will be introduced is extremely fluid. Both the president and Congress have expressed their intent to address federal tax reform in 2017 as well as a full agenda of other issues. Legislative focuses have changed quickly in the last few months, with proposed reforms to the Affordable Care Act resurging in late September. The proposed areas of reform are simply a starting point and should be treated as such until a bill is introduced.
Many questions encompass how tax reform will come to life: When will reform occur? What are the major policy drivers? What shape will tax reform ultimately take? And most importantly, how will reform impact your business and your personal finances?
The key takeaway is that no matter the shape of federal tax reform, businesses should be considering what they can do now; and much that is actionable, lies in your state tax planning. Regardless of the ultimate product of tax reform, there is plenty to do in the state and local tax environment.
State tax reform happening in waves
State tax reform is slowly coming in waves. The first wave was the collective state response to lower state tax collections which resulted in budget shortfalls that took center-stage throughout the 2017 legislative sessions. The second wave of reform will be in response to the ultimate product of federal tax reform.
In the low tide of state tax reform: The first wave
Contending with weak growth in overall state tax collections, the states have collectively faced revenue shortfalls. It was estimated that up to 40 states faced shortfalls in 2017, creating deficits for the 2018 fiscal year. In 2016, state tax revenues came in well below forecasted, forcing states to perform mid-year budget adjustments and ultimately contributing to the shortfalls currently occurring in most states. Weak tax collections are expected to continue throughout 2017 and into 2018.
State tax revenue data provided by the U.S. Census Bureau indicates minor growth in total state tax collections in 2016. State sales and use taxes and individual income taxes – the two primary tax revenue generators saw anemic growth in 2016. Initial tax collection data for the first two quarters of 2017, however, shows some signs of positive growth among sales taxes and individual income taxes, but it is still too early to recognize any meaningful trends in that data.
What does this mean?
State legislative priorities in 2017 were primarily addressing existing tax revenue shortfalls, and not the myriad of possible impacts from federal tax reform. However, that does not mean states were unaware of federal tax reform or were not already responding to federal tax reform through preemptive actions.
Based on current state tax revenues, we would expect to see the traditional responses to fiscal uncertainty and, to a great extent that has occurred. The states have traditionally balanced budgets using a number of revenue-generating methods, including a combination of the following: new taxes or increased rates, especially “sin taxes” – taxes on alcohol and tobacco; spending reductions; pension reform; increased borrowing; increased state audit activity; elimination or suspension of exemptions and nexus reform among all taxes.
Predictably, many of these methods were utilized in 2017. Corporate tax rate reductions generally continued in states like New Hampshire, North Carolina, and Washington, D.C., although state corporate tax revenues are often under five percent of total state tax collections – resulting in little overall impact to collections. However, increases or continuations of increased individual income tax rates will likely have more positive impacts on overall state revenues, such as in California, Illinois or Maine.
Additionally, a number of state tax amnesties were enacted in 2017, providing a quick, one-time “shot of revenue” to cash strapped states. In 2016 and 2017, a number of states scheduled or held state tax amnesties, including Alabama, Arizona, Massachusetts, New Hampshire, New Jersey, Ohio, Oklahoma, Pennsylvania, Rhode Island and Virginia. If slow growth continues among state tax collection revenues, expect more amnesties in 2018.
A few states took steps to counter potential federal tax reform. Oklahoma froze individual income tax standard deductions currently coupled to the federal standard deductions. While this state-level change will increase revenue in the short term (the federal deduction is increased for inflation, whereas the new Oklahoma provision is not), the intent behind the legislation appears targeted at the federal reform proposals which have called for increasing the standard deduction – a measure certain to decrease state revenue in those states coupled to the federal deduction.
The state of Kansas enacted a reversal of tax policy that had provided exemptions for certain pass-through income. The provisions, enacted several years earlier, had become unpopular due to increasing budgetary deficits caused by the exemptions. Kansas chose to address their budget woes head on with significant reform – a response we may see from other states if deficits continue in the 2018 fiscal year.
In the high tide of state tax reform: The second wave
The second wave of tax reform will be the state responses to federal tax reform. What provisions are ultimately adopted and how those will impact state revenues will be a driving force for state legislative agendas?
If any of the current federal proposals are enacted, states may need to take quick legislative action in response. Whether its depreciation to expensing, increases to the standard deduction, or repeal of the federal estate tax – many of these provisions will have impacts on both state revenues and the overall state tax spend of businesses. Timing is crucial, and if reform is enacted for the 2018 tax year, state legislatures will be modeling impacts of reform at the start of next year’s sessions.
Between current state budget shortfalls and federal tax reform on the horizon, it is becoming increasingly likely that state and local tax burdens may become a more significant portion of a business’s overall tax spend. Therefore, regardless of what reform looks like, businesses should be preparing for a greater emphasis on state and local taxes and considering and addressing how those changes may impact the formation of new entities, potential merger and acquisition activity, operational changes, footprint changes, new investments, supply changes, intercompany transactions, and individual planning considerations.
Currently, the federal legislative calendar does not leave the states much time to respond, especially if any federal tax reform proposals are made retroactive to Jan. 1, 2017. Almost all of the states have concluded their legislative sessions for the year, meaning that retroactivity could cause states to hold special sessions to address federal reform in 2017. Regardless of the timing, taxpayers must be prepared to address federal reform as Congress inches closer to meaningful change.
For more information on tax reform, see our Tax Reform Resource Center.