January Tax Retrospective: Congress Acts, States React

In a typical year, establishing conformity with the federal tax code is a fairly mundane task for state lawmakers. Since state income tax systems are generally based on the federal code, updating the connection to the Internal Revenue Code is usually uncontroversial. But with the passage federal tax reform late last year, these once-boring conformity bills have taken center stage.

When Congress passed the Tax Cuts and Jobs Act (US HR 1) last December, states were left scrambling to figure out what it would mean for them. While some projected windfall revenues and others worried about falling behind, all were agreed that the new law would affect nearly every state, but in different ways. In the face of this uncertainty, governors and legislators were left with the question of how they would respond. So far, the reactions have varied widely.

“Blue” states' reaction to the new federal limitation of the state and local tax (SALT) deduction has captured most of the media attention. A number of jurisdictions are considering bills that purport to allow taxpayers to convert nondeductible tax payments into deductible charitable contributions made to certain state-sponsored charities. Examples of these kinds of bills can be found in California, Maryland, and the District of Columbia.

Interesting, this is an idea that's also catching on in states that don't even have a state-level income tax. In Washington State, lawmakers have proposed a measure that would provide taxpayers a retail sales and use tax exemption for qualified donations. If enacted this could lead to a number of interesting administrative and compliance issues, which would hopefully be ironed out as the process unfolds.

Other states, such as New York and Virginia, are taking the tact of introducing standard “coupling” legislation, but changing the date of conformity in bypass tax reform. A normal federal coupling bill would typically be written something like this: “The state tax code will rely on all definitions and procedures established under the federal code as it existed on December 31, 2017.” Under these workaround bills, states are coupling with the federal code as it existed on some date prior to the passage of tax reform (so far a popular choice is December 1).

The most extreme legislative proposal that we've seen so far, however, comes from California, where a proposed constitutional amendment would levy a ten percent surtax on corporations with annual revenues of more than $1 million. The bill's sponsors say that the proposed constitutional amendment is necessary in order to ensure that the state's big businesses are paying their fair share. Interestingly, the proposal would also apply to S corporations, not all of which benefit from the new federal regime. Under this proposals, small business owners with sufficient California income could be subject to combined state and federal marginal tax rates as high as 60.3 percent. It's important to note, however, that this measure faces almost insurmountable political and policy hurdles.

Some states are also pursuing judicial remedies in addition to their legislative efforts. A coalition of three northeastern, Democrat governors have announced their plans to file suit alleging that Congress' decision to cap the SALT deduction violates the Constitution. They seem to be arguing specifically that tax reform unlawfully targets certain primarily Democratic states, which, as the general legal consensus acknowledges, is a spurious argument since the federal government has plenary authority to define what constitutes the federal tax base. These suits are better thought of as a political action than a serious policy challenge.

We will have to wait and see which, if any, of these efforts prove successful but they underscore what a fundamental shift federal tax reform has been upon these states. Regardless, these are just the first reactions to what will ultimately prove to be a multi-year effort to reshape state tax systems in light of the challenges — and opportunities — associated with federal tax reform.