March 16, 2006

TAX CUTS PROPOSED IN PRESIDENT’S BUDGET WOULD ULTIMATELY CAUSE LARGE STATE REVENUE LOSSES
By Iris J. Lav

Summary

When the federal government cuts taxes, those tax cuts sometimes cause reductions in state revenue as well.  This occurs because most states with individual and/or corporate income taxes use the federal definitions of adjusted gross income and corporate income as the basis for their own income taxes.  When a tax cut reduces the amount of income that is taxable for federal tax purposes, it often also reduces the amount of income taxable for state tax purposes.

The fiscal year 2007 budget that the President submitted on February 6 includes large proposed new tax cuts.  At least 16 of the tax-cut provisions proposed in the budget would affect state revenues, causing states to lose as much as $38 billion over the next ten years.  Of the 16 provisions that would affect state revenue, 13 would reduce revenue while three would result in very small state revenue gains. 

Among the provisions that would reduce state revenues are:  the expansion of tax breaks for Health Savings Accounts, a permanent increase in expensing for small businesses, permanent extension of the higher contribution limits for IRAs and 401(k)s enacted in 2001 and consolidation of employer-based retirement accounts, allowance of tax-free withdrawals from IRAs for charitable giving, and expansion of Opportunity Zones.  Another set of provisions — the expansion of Roth IRAs (renamed Retirement Savings Accounts) and the creation of Lifetime Savings Accounts — would increase both federal and state revenues in the near term but cause larger federal and state revenue losses over time.  Similarly, a proposed change in the required funding for single-employer pension plans is designed to yield short-term revenue gains but would result in long-term revenue losses.  (The tax cuts are listed in the Appendix table.) 

Table 1 shows the potential revenue loss by state over the next five years and the next ten years.[1]

• States would lose a total of approximately $8 billion over the next five years if the proposed revenue changes were enacted.

• Some of the largest losses in dollar terms over the next five years would be likely to occur in New York, Illinois, Massachusetts, North Carolina, Virginia, and Georgia.

• The state revenue loss in the second five years would be $35 billion, more than four times the loss in the first five years, bringing the ten-year loss to $43 billion.  The state losses mount rapidly after the first five years because the revenue-reduction impact in the first few years is partially masked by provisions, such as the changes in the treatment of retirement accounts, that raise some revenue in the short run but generate much larger revenue losses after that.

• By 2016, the annual revenue loss for states would reach $8.1 billion.

• The states with the largest ten-year revenue losses, in dollar terms, include New York, California, Illinois, North Carolina, Massachusetts, Ohio, Virginia, Georgia, Pennsylvania, and Michigan.[2]

Table 2 provides a different way to look at the state revenue losses that could occur — in per capita terms rather than simply in overall dollar terms.  Like Table 1, it examines the revenue losses for both the first five and the second five years. 

• The states that could experience the largest per-capita losses in the second five years, when the full losses would first appear, are Massachusetts, Oregon, New York, Minnesota, Connecticut, Maine, Delaware, Wisconsin, Virginia, and North Carolina.

• In Massachusetts, for example, the revenue loss would average $44 per capita per year — or $176 annually for a family of four — in the period from 2012 to 2016.  That is a very significant amount of revenue for a state to try to replace.  In North Carolina, the loss would be $31 per capita per year or $125 for a family of four.

As noted, the annual state revenue loss would reach $8.1 billion by 2016, and would continue to grow in subsequent years.  That means that the largest revenue losses from these proposals would occur as the baby-boom generation retires and states begin to face the higher costs (and other issues) associated with that retirement.  Costs for state pensions, retiree health insurance, and Medicaid will increase as the baby boomers age.  States will bear a particularly heavy burden for health care for the aging population, since it is Medicaid (rather than the federal Medicare program) that pays for long-term care.  The significant revenue losses that these budget proposals would engender would make it still more difficult for states to meet these responsibilities.

The nature of these tax proposals makes it particularly likely that states will conform to the proposed changes in federal law and thus incur these revenue losses.  While there have been circumstances in the recent past under which some states have declined to accept federal tax-law changes and the attendant state revenue losses (that is, circumstances under which states have “decoupled” from the federal provisions), it would be difficult for states to avoid accepting the federal treatment of many of these particular tax cuts.  For example, if Health Savings Accounts become a major method by which Americans pay for health care — as the Administration intends — states will face strong pressures to provide tax breaks comparable to the federal treatment.  To a great degree, this pressure already has appeared; all but six of the states with an income tax have conformed at least in significant part to the federal treatment of HSAs.   (Because of the high level of conformity, this analysis assumes that all states will follow federal HSA rules by 2012.) 

Similarly, when Individual Retirement Accounts were first offered, some states denied the state tax breaks that would have corresponded to the federal treatment.  Now nearly all states conform to most aspects of federal IRA policy, making it likely they would conform to the proposed Retirement and Lifetime Savings Accounts as well.

Major Proposed Tax Changes

The following describe some of the proposed federal tax changes and their potential impact on state revenues.  These provisions account for the bulk of the revenue loss.

Health Savings Accounts

The greatest revenue loss over the next ten years would result from the proposed changes in the treatment of Health Savings Accounts.  Health Savings Accounts are tax-advantaged accounts that are used in conjunction with the purchase of high-deductible health insurance policies.  The Administration proposes a series of changes to HSA policy that are designed to make the accounts and high-deductible policies more attractive.  Most of these changes would affect state revenues.