Revised April 30, 2002
States Can Avoid Substantial Revenue Loss by Decoupling from New Federal Tax Provision
by Nicholas Johnson
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A new provision of federal tax law, signed into law March 9, threatens to reduce corporate and personal income tax revenue in nearly every state to a significant degree in the current and upcoming fiscal years. The provision is known as "bonus depreciation." It allows a business to claim an immediate tax deduction of up to 30 percent of the cost of new equipment purchases, rather than following the standard accounting approach of depreciating the full cost gradually over several years as under previous federal law. The bonus is effective retroactive to September 2001, meaning that businesses can begin immediately to claim the deduction in their tax returns for 2001 and their estimated tax payments due in spring, 2002. It expires in September 2004, by which time it will have reduced federal taxes on profitable businesses by $97 billion.
In addition to the reduction in federal revenue, states stand to lose more than $14 billion(1) in corporate and individual tax revenue over three years, because income taxes in nearly every state traditionally have been calculated based on federal tax law. Because the provision is retroactive, states that conform to it will experience immediate revenue loss.
This revenue loss would cause serious problems for states that are already struggling to balance their budgets. The National Governors Association, in a March 11 news release, described the provision as "an assault on the states' revenue base" that could result in cuts in education, health care and transportation services. The National Conference of State Legislatures has criticized the provision in similar terms. The additional spending cuts that likely would result from failure to decouple would cause harm to state economies at this moment of economic recovery.
There is a way states can protect themselves from this immediate and large revenue loss while the federal provision is in effect. States can, at their own option, "decouple" their business depreciation rules from the federal rules for the period of time that bonus depreciation is in effect. In other words, states can choose not to conform to this federal change. California already used its own depreciation schedules even before the change. Another ten states that previously followed federal rules Arkansas, Georgia, Idaho, Indiana, Iowa, Massachusetts, Mississippi, Nebraska, Texas and Virginia plus the District of Columbia have now decoupled from the bonus depreciation provision (seven of those through legislative action, three through pre-existing statutory authority). At least ten additional states appear poised to decouple, as legislation to decouple has advanced in Connecticut, Maryland, and Wisconsin, and governors or top legislators have called for decoupling in Arizona, Illinois, Ohio, Minnesota, New Jersey, Pennsylvania, and Vermont. In the early 1980s, responding to a similar federal change, some 21 states decoupled from federal depreciation rules.
Table 1 shows the approximate revenue loss to each state in fiscal years 2002, 2003 and 2004 if they conform to the new federal depreciation rules. It reflects official revenue estimates from individual state tax departments, where available; for the remaining states, it reflects Center on Budget and Policy Priorities estimates based on calculations by Congress' Joint Committee on Taxation and the Congressional Research Service.
How Can States Avoid This Loss?
In some states, the revenue loss from bonus depreciation will occur automatically in the absence of legislative action. In other states, this revenue loss will occur if states pass legislation to update their tax codes to incorporate federal changes, as has been annual standard practice in recent years.
Although most states in recent years have conformed to federal depreciation rules, there is no obligation to do so. There is ample precedent and opportunity for states to use their own depreciation rules that differ from federal rules.
- California for a number of years has used its own depreciation rules, different from federal rules, for computing corporate and personal income tax. There is no evidence that the additional bookkeeping requirements have impeded economic development in California.(2)
- When the federal government sharply increased depreciation allowances in 1981 by adopting the "accelerated cost recovery system," about half of the states promptly decoupled in whole or in part. The states included Alaska, Arkansas, California, Connecticut, Florida, Georgia, Kentucky, Maine, Minnesota, New Jersey, New York, North Dakota, Ohio, Oklahoma, Oregon, Pennsylvania, South Carolina, Tennessee, Utah, Virginia, and West Virginia.(3) Several of those states, including New York, New Jersey and Kentucky, continued to require different depreciation schedules from the federal schedule for at least some industries into the early 1990s.
- Ten states plus the District of Columbia that previously followed federal depreciation rules have determined that they will disallow the new bonus provision (or taken equivalent action to decouple), and others are likely to follow. In seven states Georgia, Idaho, Indiana, Iowa, Massachusetts, Nebraska, and Virginia and in D.C. the decoupling resulted from explicit legislative action.(4) Two other states, Arkansas and Texas, do not have legislative sessions this year and therefore are decoupled automatically under pre-existing tax law. The tenth state that has decoupled is Mississippi, as a result of a ruling by the state tax commissioner that the bonus depreciation deduction fails to meet the state standard for a "reasonable allowance" for depreciation.
- Legislation to decouple is expected to advance in at least ten other states that are still developing their budgets for next fiscal year. Decoupling legislation has won support from joint legislative finance committees in Connecticut and Wisconsin; in Maryland, a bill to decouple awaits the governor's signature. Governors in Arizona, Minnesota, New Jersey, Pennsylvania and Vermont have requested legislation to decouple, as have legislative leaders in Illinois and Ohio.
The Mechanics of Decoupling
For calculating corporate income tax, the starting point in most states is taxable income as defined by the federal Internal Revenue Code. Taxable income is income after allowable expenses such as depreciation. For firms that do not pay corporate income tax (such as S corporations, partnerships, and sole proprietorships), depreciation is reflected in the owners' federal adjusted gross income, which is the starting point for most states' calculations of state individual income tax liability. Because bonus depreciation reduces both the taxable income of corporations and the adjusted gross income of individuals, it can reduce states' tax bases to a commensurate degree.
States nevertheless can prevent the change from affecting them for the three years it is in effect. One method of doing so is to change the applicable reference to the federal Internal Revenue Code to specify the Code as it existed on September 1, 2001 (or on some other date prior to the September 11 effective date of the new provision).(5) Tax departments then can revise tax forms and/or instructions so that businesses add to their federal income the amount by which depreciation under the new, temporary "bonus" provision is greater than depreciation under permanent law. Many states already require corporations to make various additions and subtractions to federal taxable income to calculate taxable income for state purposes; a revised state tax form might include one additional line for a corporation to add back the bonus depreciation amount.(6)
Any complications that would be caused by decoupling would be temporary, since the federal change expires in less than three years. In addition, note that small businesses with $24,000 or less in annual equipment purchases generally are unaffected by bonus depreciation rules because such businesses account for capital expenditures in a different way.
Impact on State Budgets
Conforming to the federal changes will hit states with an additional revenue loss that they cannot afford. As a result of the recession, the terrorist attacks, last summer's federal tax changes, and rising health care costs, among other factors, most states are experiencing very tight fiscal times. Many had already planned or enacted spending cuts and tax increases. Any additional spending cuts or tax increases required to replace revenue lost as a result of bonus depreciation conformity would be unpopular and difficult.
Recognizing the potential fiscal danger to states from the bonus depreciation provision, organizations of state officials such as the National Governors Association and the National Conference of State Legislators asked Congress to include fiscal relief in the form of additional Medicaid funds in the stimulus bill. "States must keep their budgets balanced and without relief, the result will be steep cuts and tax increases that might threaten economic recovery," NGA Chairman John Engler told members of Congress. Congress, however, chose not to provide such relief.
Three Years of Bonus Depreciation Is Not Effective Economic Stimulus
and Can Create Economic Distortions
There is significant doubt as to the effectiveness of the three-year federal bonus depreciation provision in creating economic growth. Last fall and early this winter, a number of economists advised that such a proposal could provide useful near-term stimulus if it were made effective for one year. Doing so would encourage firms to accelerate purchases into 2002 to take advantage of this tax break.
But the enacted legislation makes the provision effective for three years rather than one. According to the nonpartisan Congressional Budget Office, the three-year term weakens the provision's ability to stimulate the economy. "Temporarily cutting taxes on investment can provide one-time opportunities for saving that may induce firms to advance their investment plans to the present," CBO noted in a January report, but firms "might not take [such action in the near-term] if they knew that the tax advantage would remain in place and be available to them later."
Bonus depreciation allows a large share of the cost of investment to be counted as an expense in the first year rather than subtracted gradually over the life of the asset. This "partial expensing" could create unintended economic problems when the economy returns to full employment, as is likely to occur before the provision expires. For example, among the types of investments that it does cover, partial expensing reduces the costs of longer-lived investments more than shorter-lived investments and thereby biases firms toward making longer-lived investments even if that would not make economic sense in the absence of the tax provision. More broadly, by spurring demand for covered investments, partial expensing puts upward pressure on interest rates and thereby dampens demand for investments not covered by the partial expensing (such as residential housing). Partial expensing can thus skew incentives toward particular types of investment and away from other types. In other words, partial expensing can distort economic decisions and create economic inefficiencies.
Conforming to the federal change would exacerbate a trend toward lower corporate taxation at the state level. State corporate income tax payments, as a share of total corporate profits, have declined dramatically over the last decade, from an average effective rate of 6.5 percent in the 1980s to about 3.8 percent in 1998. In part this has occurred because multi-state corporations increasingly are able to exploit shortcomings in state tax law to minimize their tax payments.(7) By decoupling, states can prevent additional erosion of the corporate tax base.
Impact on State Economies
The tax hikes or spending cuts needed to balance state budgets would have another effect as well: They would take money out of state economies at a time when states should be contributing to economic activity, not preventing it. For every dollar that bonus depreciation would put into the hands of corporations in the form of a tax break, the state would have to take a dollar away from state or local workers or contractors, or from other taxpayers. Because states must balance their budgets, the combination of conforming to bonus depreciation while cutting spending would at best be a zero-sum game and have no effect on state economies. However, as economists Peter Orszag and 2001 Nobel Prize winner Joseph Stiglitz have noted, cutting spending on goods and services to pay for a tax cut could hurt a state's economy and slow an economic recovery.(8) For example, a $1 reduction in direct state spending on goods and services reduces consumption within the state by at least $1. The new tax break is unlikely to provide sufficient stimulus to offset the effects of the spending cuts it would cause, because the businesses would not necessarily spend all of the tax break; some is likely to be retained as savings by the corporation. Moreover, as explained below, businesses are highly likely to spend their tax break in a state other than the one that is providing the tax break.
It is worth noting that state decoupling will not impair a corporation's ability to benefit from the federal bonus depreciation provision. In other words, regardless of state action, corporations will receive a very generous investment incentive through their federal tax returns. Since federal tax rates are higher than state rates, the federal deduction for bonus depreciation is far more valuable than any state deduction would be.
One reason that Congress chose not to provide fiscal relief to states in the stimulus bill may have been a belief that states could protect themselves by decoupling from the provision.(9) In other words, the expectation that the bonus depreciation would assist the U.S. economy, whether correct or incorrect, was not dependent on states conforming to it.
A further reason to question state conformity to the bonus depreciation rule is that states are likely to suffer a substantial revenue loss to subsidize investments made in other states. Multi-state corporations pay taxes to each state where they operate based on their total income minus total expenses, including depreciation; the amount that they pay to each state is based on the extent of their physical presence and sales in the state, not on where their expenses occur.(10) And states are barred by the U.S. Constitution from requiring corporations to depreciate out-of-state equipment purchases less favorably than in-state equipment purchases. No matter where the equipment is purchased, it would reduce taxable income. Thus, if a corporation replaces a piece of equipment at a factory out of state, it would receive the exact same bonus depreciation deduction as it would for replacing a piece of equipment within the state. Since multi-state corporations represent a large portion of most states' corporate tax bases, much of the cost of conforming to the temporary depreciation rule would subsidize out-of-state investments.(11)
The change to federal depreciation rules that is now in effect, and will remain in effect for another 30 months, threatens to do significant damage to state budgets without benefitting state economies. To avoid this damage, states must depart from the practice of the last several years of routinely conforming to changes in federal tax law. Instead, as many did in the early 1980s, states will have to adjust their tax forms and instructions to recapture the lost revenue.
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. Nevada, Washington and Wyoming do not have income taxes based on federal definitions of income; California does not conform to federal depreciation provisions.
All other states, plus New York City and the District of Columbia, historically have utilized federal depreciation schedules in computing corporate and/or personal income taxes.
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; see text for discussion.
Estimates marked with an asterisk (*) are official published state estimates where available. All others are approximations based on the federal Joint Committee on Taxation (JCT) estimate of impact on federal tax receipts ($97 billion over three federal fiscal years). Using the JCT estimate, the Congressional Research Service (CRS) has estimated the effect of the provision on states to total between $14 billion and $15 billion over those three years. The approximations shown here were developed by updating the CRS estimate to reflect the most recent JCT estimates and then distributing the result among affected states, based on the size of each state's actual corporate and personal income tax receipts. Most state fiscal years are different from the federal fiscal year, and corporate filing rules also differ state to state; amounts were adjusted accordingly. In nearly all affected states, additional revenue losses are expected to occur in FY 2005, not shown here.
1. This amount includes the expected revenue loss from investments made through September, 2004, the month in which the provision is scheduled to expire.
2. Since the California rules apply to equipment outside of California as well as within California, and since nearly every large corporation has a California presence and files a California tax return, the California rules apply to a large share of all depreciable assets in the United States. In 1998, for instance, total depreciation on California corporate returns equaled about 68 percent of total depreciation on all federal corporate returns nationwide.
3. At least four other states, Indiana, Iowa, Nebraska, and Wisconsin, raised corporate income tax rates to offset the revenue loss due to the federal changes. Sources: Advisory Commission on Intergovernmental Relations, Significant Features of Fiscal Federalism, 1982-83 Edition, pp. 68-70; Federation of Tax Administrators, Tax Administrators News, February 1984; National Conference of State Legislatures, The 1982 Federal Tax Increase and State Revenue: The Major Issues, January 1983.
4. In Georgia, Idaho, Indiana, and Iowa, the decoupling was accomplished by updating tax codes to conform to other recent federal tax law changes but chose not to conform to the bonus depreciation change, thereby remaining decoupled from that provision.
5. Some states have avoided conforming to the bonus depreciation provision by referring to the Internal Revenue Code as it existed on January 1, 2002, which presumably would exclude the bonus depreciation provision. A reference date of September 1, 2001, however, would be clearer.
6. Under this approach, additional adjustments in later years may be appropriate in order to allow businesses to deduct the full value of the purchase over time. These additional adjustments can create new accounting and administrative burdens on businesses and state tax administrators. The new federal tax law has prompted a number of state revenue departments and legislatures to begin developing other approaches to decoupling in order to minimize those accounting and administrative burdens while avoiding substantial revenue loss; one example is the decoupling legislation enacted in Nebraska, LB 1085.
7. Steve Maguire, Average Effective Corporate Tax Rates, Congressional Research Service, February 29, 2000; Peter Fisher, "Tax Incentives and the Disappearing State Corporate Income Tax," State Tax Notes, January 17, 2002.
8. Peter Orszag and Joseph Stiglitz, Budget Cuts vs. Tax Increases at the State Level: Is One More Counter-Productive than the Other During a Recession? Center on Budget and Policy Priorities, November 6, 2002 (http://www.centeronbudget.org/10-30-01sfp.htm).
9. For instance, this point was made by the staff director for the U.S. House Ways and Means Committee in a December meeting with state legislators who chair tax and finance committees.
10. Specifically, the share of a corporation's nationwide profits taxed in a particular state generally depends on the shares of the corporation's nationwide property, payroll, and/or sales located in that state.
11. The same can be said with respect to the state personal income tax revenue losses flowing from the bonus depreciation provisions, since many "S" corporations, partnerships, and Limited Liability Companies also have multistate operations. Depreciation deductions taken by such business entities flow through to the state personal income tax returns of their owners.