How Federal Tax Reform Impacts States

As the 2016 presidential race gets under way, many politicians will call for their own brands of federal tax reform. It’s a topic that can seem pretty remote to state and local government affairs, but major changes at the federal level have a direct impact -- for better or worse -- on state tax collection.

That’s because most state tax codes are connected to the federal tax system in one way or the other. For example, 31 states and the District of Columbia allow federal itemized deductions, and in about half the states, taxpayers calculate their earned income tax credits based on the federal rate. Any changes to deductions or the tax credit would trickle down to these states and directly affect their revenue. “The national debate on tax reform doesn’t tell the whole story,” said Anne Stauffer, who heads up the Pew Charitable Trusts’ Fiscal Federalism Initiative. “The federal government will make changes, and states will have to make some decisions because of that.”

 
Stauffer's point -- explored in a recent analysis -- isn’t just a theoretical one. Nearly 30 years ago, Congress passed the Tax Reform Act of 1986 in an effort to simplify the income tax code by reducing the number of deductions and the number of tax brackets. The act also lowered the tax rate for the top tax bracket from 50 to 28 percent, raised the bottom bracket's rate from 11 to 15 percent, eliminated some tax shelters and loopholes, increased the standard deduction, and raised corporate and capital gains tax rates.



Following the federal reforms, states enacted a myriad of policy responses, according to an analysis by tax economist Steven Gold in the National Tax Journal. Ohio was the first to reduce its income tax rates to offset the projected increase in tax revenue. Several states also eventually sought full or partial revenue offsets via either a tax rate reduction, an increase in the standard deduction or a boost to the personal exemption.

Nine states, nearly all with weak economic conditions in 1986 and 1987, decided to keep the windfall from the federal reforms. While a few states, like Rhode Island and Vermont, were adversely affected by the federal changes and responded by increasing their tax rates to offset potential revenue losses. Meanwhile, West Virginia redesigned its whole income tax structure.

Economic conditions played a bigger role in 2002 when Congress reformed the tax structure again. The new federal law temporarily expanded deductions for equipment purchased by companies in order to encourage them to invest in things like new computers or machinery. But most states were still trying to rebound from lower revenues following the 2001 dot com crash, and so 23 states and D.C. immediately severed their own laws from the federal one to avoid revenue losses.

States are in a similar boat today, still adjusting to what has been the slowest economic recovery following a recession in the modern era. At the same time, conservative lawmakers at all levels in recent years have signed on to Grover Norquist’s antitax pledge, promising to never raise taxes. It is this economic and political climate that will determine how states react to federal changes. That's why Stauffer recommends that state policymakers start thinking now about how to respond should a new federal tax reform pass. “The key is what kind of change,” she said. “This could be a concern for policy folks in terms of thinking about how much revenue they want to raise -- or not -- in their state.”