How States Should Respond to the Federal Tax Changes

As we’ve said, many states expect to see a change in revenues under the federal tax law. But states should respond very cautiously to the possibility of a revenue boost and focus their response on preparing for potential cuts in federal funding for states, as well as the next recession, as our new report suggests.

They also should strongly consider raising revenue from corporations and other wealthy interests receiving a large tax break under the new law in order to invest in stronger education systems, more efficient transportation networks, and other public services that undergird broadly shared prosperity.

In response to the federal tax changes, states should:

• Build their reserves to prepare for potential cuts in federal support for states and for the next recession. States would be wise to build their reserves rather than spend revenue boosts from the federal changes on tax cuts or major spending increases (without raising additional revenue, as discussed below). President Trump and Republican congressional leaders have expressed their interest in substantially cutting Medicaid and various other forms of federal support for states and localities. The new tax law, by substantially increasing the federal debt, may add to pressure for such cuts in the next few years. Further, a recession will inevitably occur at some point in the coming years; the current expansion is already the second longest in American history.
• Avoid income tax rate cuts. Some state policymakers are responding to initial projections of revenue gains by proposing state income tax rate cuts, whose cost in some cases would far exceed the projected revenue. These proposals would hamper a state’s ability to address potential cuts in federal aid and other looming budget challenges. They also would further widen inequality, since rate cuts typically benefit the wealthy more.
• Retain state personal and dependent exemptions. In some states, the loss of federal personal exemptions could mean the loss of state-level personal or dependent exemptions, raising revenue in a way that would fall hardest on lower-income families. These states should carefully examine their tax codes to determine whether they would lose their state-level personal exemptions. If so, these states should enact legislation to retain them, rather than use the regressive revenue gains on new tax cuts or spending increases. States should also consider converting their exemptions to credits, which would help lower-income families more as a share of their income.
• Decouple from provisions that weaken state revenue systems. States should take the necessary steps to avoid losing substantial revenue due to the federal tax changes, especially given the challenging fiscal environment in which they operate. For instance, states whose tax codes are coupled to the federal standard deduction, which has doubled, may wish to retain their current standard deductions. States also should consider retaining their current rules for deducting equipment and machinery purchases (given the revenue impact of federal changes in this area) and retaining their current exemption amounts for estate taxes.
• Consider raising revenue from corporations and the wealthy. The federal tax law’s extraordinary windfall for corporations and very high-income households will further concentrate income and wealth at the top. States may wish to distance themselves from this approach, offsetting some of the gains at the top through tax increases and by investing the revenue in education, transportation, and other public services that aid middle- and lower-income Americans and fuel broadly shared prosperity. For instance, states could seek to recoup in whole or part the misguided federal tax cut for “pass-through” businesses (sole proprietorships, partnerships, and S corporations), to close corporate loopholes the new law expands, or to raise top income tax rates.
• Consider SALT “workarounds” as part of broader plan. Some high-income states with a disproportionately large share of taxpayers affected by the new $10,000 cap on state and local tax deductions (SALT) are investigating ways to restructure their tax codes to protect taxpayers from the cap. States heavily affected by that cap should give such “workarounds” thoughtful consideration — and should do so as part of a more comprehensive response to the law’s effects.