Taking Control of the State Tax Base During the Pandemic

COVID-19 has impacted society in nearly every dimension, and state and local governments have been hit especially hard. Those governments are simply not equipped to deal with major revenue shocks like those that accompany a global pandemic. In that vein, a group of scholars has joined forces to create Project SAFE (State Actions in Fiscal Emergencies), which is focused on providing research-backed policy recommendations for states. Among the project’s areas of focus is how states can help themselves by modifying their own taxing and spending programs and priorities.

One of the features of state taxation that I have been looking at quite a bit in recent years is states’ conformity practices—states using the federal tax code for purposes of defining their own tax bases. Roughly one half of states conform to the federal tax code on a rolling basis, which means that they automatically incorporate changes to the federal tax laws into their own tax laws. The other half adopt the federal tax code on a static or fixed basis, which means that they adopt the federal tax code as of a particular date and then update that date to incorporate new federal changes. A handful of states technically apply their own tax codes without relying on the federal tax code, but those states largely replicate the federal tax code through explicit adoption, much like static conformity states.

That practice of conforming, piggybacking or “delegating up” allows states to gain significant efficiency benefits in the writing, administration, and enforcement of their tax codes, but conformity also subjects states to significant revenue volatility by delegating first-order decision making to Congress. States very clearly felt the effects of conformity in the wake of the Tax Cuts and Jobs Act of 2017, and many states are still determining how to respond.

States now also have to consider whether and how to respond to the changes made in the Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”) and any potential future legislation making changes to the federal tax code in response to the pandemic. On the corporate income tax side, the major changes made in the CARES Act included adjustments to the business interest deduction, the net operating loss rules, and the TCJA’s full depreciation allowance. Each of those changes provided tax relief for certain businesses, but their adoption by states would reduce state tax revenues and further endanger states’ fiscal stability. States thus have to decide whether to conform to those changes or to deviate from the federal tax code.

States may want to conform to those changes as a way of helping businesses that are struggling during the pandemic. Admittedly, that has some instinctive appeal. The large-scale shuttering of the in-person economy has impacted businesses just as it has individuals and the states. State tax relief might seem like an obvious way to provide relief to businesses that are otherwise struggling.

Unfortunately, though, states are ill-suited to provide stimulus funding to businesses at this time. States are largely bound by balanced budget requirements, which limit them from deficit spending during downturns like the current pandemic. At the same time, state spending is largely focused on vulnerable populations.

States should currently be focused on expanding programs like unemployment insurance and Medicaid, not cutting off their funding. Tax cuts would work against that goal and states’ primary mission—supporting the health and welfare of their residents. States operate in a world where every dollar of tax cut comes with some expense to the general health and welfare of the public.

The solutions to this problem are multiple and cannot be communicated in one blog post. I do think, though, that states can follow some general principles to ensure that they best pursue welfare maximization within their borders.

First, states and taxpayers must press on the federal government for significant, unrestricted aid to the states. Second, states and taxpayers must also look to the federal government, and not state and local governments, to provide relief to the businesses in need. The federal government is again better positioned than the states to provide that relief, and the federal government can better tailor its efforts if those programs are not being haphazardly duplicated at the state and local levels.

Third, states should take charge of their tax codes by adopting static conformity at least for some period of time. New York, for example, recently changed its default of rolling conformity to static conformity for tax years beginning before January 1, 2022. That move will allow that state to carefully consider changes that Congress makes as it moves forward with legislative responses to the pandemic.

Fourth, rolling conformity states should decouple from the changes made by the CARES Act unless and until their legislatures determine that those changes were either de minimis or that the state would benefit in some way from making those changes. Despite the intuitive or political appeal of providing state tax relief during these times, states cannot be the engines of stimulus. State spending programs are currently getting individuals medical assistance, keeping them sheltered an fed, and allowing them to stay home to slow the spread of the virus. Providing targeted tax relief based on Congressional action and federal policymaking is not likely a luxury that states or their residents can afford at this time.

Finally, states must consider the overall distribution of their tax burdens and consider asking for more from their most well off. Whether that comes in the form of new taxes, like state wealth taxes, or modifications to existing taxes, like progressive property taxes or strategic conformity with, or decoupling from, the TCJA, states will need to raise revenue to maintain their residents’ health and safety and their own futures as thriving political and economic units.

In the end, we know that states’ budgets are subject to many outside forces, and most of those forces will put further strain on states’ resources for the foreseeable future. States can take better control of their finances by thinking more critically about where and how they conform to the federal tax code and by carefully analyzing any proposed tax cuts and the systemic effects that those cuts would have.

 

 

 

 

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