PRESERVING STATE REVENUE FROM THE EFFECTS OF RECENT FEDERAL LEGISLATION
States Can "Decouple" from Federal Tax Changes
by Iris J. Lav, Elizabeth McNichol, and Nicholas Johnson
PDF of this report If you cannot access the files through the links, right-click on the underlined text, click "Save Link As," download to your directory, and open the document in Adobe Acrobat Reader. At a time when states across the country are facing severe budget problems, two recent cuts in federal taxes could exacerbate fiscal stress. The new federal laws could force states to forego tens of billions of dollars in revenues over the next few years. The loss of this revenue would jeopardize spending on a range of state programs, including spending on low-income and human services programs.
States can avert this loss of revenue and maintain adequate resources to support programs by "decoupling." Decoupling means protecting the relevant parts of their tax code from the changes in the federal tax code, in most cases by remaining linked to federal law as it existed prior to the change. A number of states already have acted to decouple.
What Are the Federal Tax Changes and How Do They Affect States?
Estate Tax
- Last summer's tax legislation includes a phaseout of the federal estate tax, culminating in full repeal in 2010. On a much faster track, the legislation repeals over the next four years the federal estate tax credit to which all state estate taxes are tied.
- The elimination of the federal estate tax credit will effectively repeal most state estate taxes, unless states change the way they link to the federal law. This is because most state estate taxes use the federal credit that is being phased out over the next four years as the basis for the calculation of state estate tax liability.
Bonus Depreciation
- The economic stimulus legislation Congress approved this spring allows firms to claim an immediate federal tax deduction of up to 30 percent of the cost of new equipment purchases, rather than depreciating the full cost gradually over several years as under prior law.
- The vast majority of states historically have used federal depreciation rules for computing state business taxes (with the exception of period following the 1981 federal tax cut, when 21 states decoupled). As a result of the recent stimulus legislation, most states will be forced to give businesses an additional tax break, on top of the federal break, unless they decouple from the federal provision.
How Much Will States Lose?
- If states allow the loss of the federal estate tax credit to repeal their own estate taxes, they will lose $23 billion over the five year period from fiscal year 2003 to fiscal year 2007.
- Conforming to federal bonus depreciation will cost states more than $14 billion between now and September 2004.
Shouldn't States Go along with These Federal Changes In the Hope That Reducing State Taxes Will Boost the State's Economy?
- When loss of revenue causes states to cut services, the economy usually is harmed rather than helped. Reductions in government spending withdraw demand from a state economy and thereby can weaken it.
- Cutting government services can harm the business climate. Businesses rely on a well-educated workforce, good transportation and public safety services, and a range of other government programs and services that create healthy conditions for business operations.
- The bonus depreciation provision cannot be limited to in-state investment. If states conform to the federal bonus depreciation change, they would be giving many businesses a tax break for investment that takes place in some other state.
- For every dollar that the wealthiest two percent of estates save in estate tax or corporations gain in the form of a tax break, other state residents including low- and middle-income families would lose a dollar worth of state programs and services or have to pay an additional dollar in taxes.
What Can States Do?
Choosing whether to enact a major tax cut such as bonus depreciation or estate tax repeal should be a deliberate decision by a state, not something that is forced on states by federal actions. To the extent that these federal changes are harmful to state fiscal conditions, states can take action to mitigate the harm. Specifically, states can maintain their own estate taxes based on the federal credit prior to repeal, and states can continue to use the regular federal depreciation schedules or make equivalent adjustments.
Effects on States of Estate Tax Repeal and Bonus Depreciation
Estate Tax Bonus Depreciation Federal tax change phaseout of federal credit for state estate taxes paid. "bonus depreciation" provision of 2002 economic stimulus legislation Effective date Credit is phased out over four years, beginning in 2002 bonus is effective retroactive to September 2001 and expires September 2004 Effect on states effectively repeals most state estate taxes reduces state corporate and individual income tax revenue Potential revenue loss to states $19 billion to $23 billion between fiscal years 2003 and 2007 more than $14 billion between now and September 2004 States that could potentially be affected every state except Oklahoma every state except California, Nevada, Washington, and Wyoming Will all of these states automatically be affected? no; states whose tax codes are not automatically updated to reflect changes in the federal tax code will not be affected until they update their references to the federal tax code How states can "decouple" from the federal action change state law so the elimination of the federal estate tax credit does not affect the state estate tax maintain depreciation rules that existed prior to the new bonus depreciation for the period the new federal rules are in effect States that are decoupled Arkansas, D.C., Kansas, Maine, Maryland, Minnesota, Nebraska, New York, Oregon, Rhode Island, Virginia, Washington, Wisconsin Arkansas, D.C., Georgia, Idaho, Indiana, Iowa, Maryland, Massachusetts, Mississippi, Nebraska, Texas, Virginia For additional information, including data on the potential revenue loss for each state and details on the specific decoupling steps that states can take, see the following Center reports:
States Can Retain Their Estate Taxes Even as the Federal Estate Tax Is Phased Out, by Elizabeth C. McNichol, Iris J. Lav, and Daniel Tenny, January 31, 2002
States Can Avoid Substantial Revenue Loss by Decoupling from New Federal Tax Provision, by Nicholas Johnson, April 29, 2002
Estimate of Revenue Loss that Can Be Avoided by
Fully Decoupling from Federal Estate Tax ChangesRevenue Loss that Can Be Avoided (millions) Total State FY 2003 FY 2004 FY 2005 FY 2006 FY 2007 FY 03-07 For States With a Pickup Tax Only Alabama $15.1 $28.4 $43.4 $56.5 $59.9 $203.3 Alaska 0.7 1.5 2.3 3.1 3.5 11.1 Arizona 18.4 40.8 64.6 86.8 96.3 306.9 Arkansas 6.4 14.3 22.6 30.3 33.7 107.3 California 230.5 510.6 808.0 1,085.7 1,205.1 3,839.9 Colorado 20.4 45.2 71.5 96.0 106.6 339.6 Delaware 10.2 22.5 35.6 47.9 53.2 169.4 District of Columbia 16.9 31.9 48.8 63.6 67.4 228.6 Florida 189.3 419.3 663.6 891.7 989.8 3,153.7 Georgia 31.5 69.7 110.3 148.2 164.5 524.2 Hawaii 4.3 9.6 15.1 20.3 22.6 71.9 Idaho 2.7 6.0 9.5 12.8 14.2 45.2 Illinois 89.1 197.3 312.3 419.6 465.8 1,484.1 Kansas 10.2 22.5 35.6 47.9 53.2 169.4 Maine 7.6 16.7 26.5 35.6 39.5 125.8 Massachusetts 50.2 111.1 175.9 236.3 262.3 835.8 Michigan 51.1 96.2 147.1 191.7 203.3 689.3 Minnesota 13.1 29.0 45.9 61.6 68.4 217.9 Mississippi 6.8 15.1 23.9 32.1 35.6 113.5 Missouri 38.7 85.7 135.6 182.3 202.3 644.6 Montana 2.3 5.1 8.0 10.8 12.0 38.2 Nevada 10.5 23.2 36.8 49.4 54.8 174.7 New Mexico 6.2 13.8 21.9 29.4 32.6 104.0 New York 118.5 341.4 563.9 785.3 915.5 2,724.5 North Carolina 30.4 67.3 106.5 143.1 158.8 506.1 North Dakota 1.3 2.9 4.6 6.2 6.8 21.8 Oregon 10.8 23.9 37.8 50.8 56.4 179.7 Rhode Island 5.4 12.0 19.0 25.6 28.4 90.4 South Carolina 12.1 26.8 42.4 57.0 63.2 201.4 South Dakota 2.1 4.7 7.4 10.0 11.1 35.4 Texas 97.2 191.8 296.5 390.2 420.0 1,395.8 Utah 7.5 16.7 26.4 35.5 39.4 125.4 Vermont 3.1 6.9 11.0 14.8 16.4 52.2 Virginia 30.8 68.3 108.1 145.3 161.3 513.9 Washington 26.4 58.5 92.7 124.5 138.2 440.3 West Virginia 4.3 9.6 15.1 20.3 22.6 71.9 Wisconsin 19.0 42.1 66.6 89.5 99.3 316.6 Wyoming 1.9 4.3 6.8 9.2 10.2 32.5 For States with Their Own Estate or Inheritance Taxes* Connecticut $36.0 $87.0 $138.0 $192.0 $200.0 $653.0 Indiana 8.5 20.1 24.0 24.5 24.5 101.6 Iowa 15.2 26.1 37.6 44.2 45.6 168.6 Kentucky 15.0 25.0 35.0 45.0 47.7 167.7 Louisiana 8.7 19.5 31.7 43.7 47.6 151.2 Maryland 21.0 42.2 63.2 82.4 87.4 296.2 Nebraska 5.2 13.1 18.3 23.6 25.0 85.2 New Hampshire 6.3 9.4 20.8 27.9 31.0 95.3 New Jersey 51.0 101.0 148.0 190.0 209.0 699.0 Ohio 7.0 18.1 39.7 40.7 43.2 148.8 Oklahoma 0.0 0.0 0.0 0.0 0.0 0.0 Pennsylvania 25.0 35.0 50.0 60.0 63.6 233.6 Tennessee 2.4 5.2 8.3 11.2 12.4 39.5 *All estimates for states with their own tax are provided by the state unless otherwise noted.
Notes: See footnotes to Tables 4A & 4B in States Can Retain Their Estate Taxes Even As The Federal Estate Tax is Phased Out. The states in italics (Arkansas, District of Columbia, Kansas, Maine, Maryland, Minnesota, Nebraska, New York, Oregon, Rhode Island, Virginia, Washington, and Wisconsin) have already decoupled for at least one year and so would not face a revenue loss. See paper for details.
Cost to States of Conforming to Bonus Depreciation Rules, By State Fiscal Year (Dollars in Millions) FY 2002 FY 2003 FY 2004 Total Alabama $49 $45 $41 $135 Alaska 31 73 52 156 Arizona 48 113 81 242 Arkansas 24 56 40 119 California n/a n/a n/a n/a Colorado 38 91 65 194 Connecticut 44 104 74 222 Delaware 5 15 15 35 Florida 126 146 124 396 Georgia 78 185 132 394 Hawaii 9 22 15 46 Idaho 14 32 23 69 Illinois 159 378 270 806 Indiana 79 187 134 400 Iowa 14 46 48 108 Kansas 25 59 42 126 Kentucky 32 76 55 163 Louisiana 25 59 42 127 Maine 13 31 22 67 Maryland 52 123 88 262 Massachusetts 118 279 200 597 Michigan 13 51 47 111 Minnesota 104 130 117 351 Mississippi 24 58 41 123 Missouri 38 91 65 195 Montana 10 23 16 48 Nebraska 0 35 32 67 Nevada n/a n/a n/a n/a New Hampshire 19 44 32 95 New Jersey 116 274 196 586 New Mexico 17 41 29 88 New York 912 545 1,457 North Carolina 86 203 145 434 North Dakota 7 16 12 34 Ohio 39 152 139 330 Oklahoma 21 50 36 107 Oregon 45 106 76 227 Pennsylvania 148 352 252 753 Rhode Island 8 20 14 42 South Carolina 25 60 43 129 South Dakota 3 8 6 17 Tennessee 48 113 81 242 Texas 198 279 253 730 Utah 19 45 32 97 Vermont 3 14 8 25 Virginia 60 143 102 305 Washington n/a n/a n/a n/a West Virginia 16 35 21 72 Wisconsin 62 146 104 312 Wyoming n/a n/a n/a n/a New York City 170 403 288 860 District of Columbia 35 32 29 96 Notes: n/a = Not applicable.
States in italics (Arkansas, Georgia, Idaho, Indiana, Iowa, Massachusetts, Mississippi, Nebraska, Texas, Virginia and the District of Columbia) are now decoupled from federal bonus depreciation provision and therefore not expected to be affected by revenue loss.