States Should Respond Cautiously to Uncertain Revenue Impacts From Federal Tax Changes

Some state policymakers have overreacted to the possibility of new revenue from the recent federal tax changes by proposing major income tax rate cuts, including some that would cost more than the highly uncertain estimate of new revenue.  While claims that most or all states will see windfall revenue gains from the federal changes are overstated, some states will gain revenue.  As we explain in our new paper, states should respond with substantial caution to estimates of the magnitude of these gains, for the following reasons:

• Revenues may fall as taxpayers find loopholes in the new federal law.  The federal tax changes were rushed through Congress, with large segments of the new law hastily written, and with little input from tax experts and others affected by the changes.  Consequently, taxpayers and professional tax preparers will likely find new loopholes to exploit, reducing their tax liability at the expense of states and the federal government. 

• Some provisions are very difficult or impossible to model.  State budget analysts will find it extremely difficult to estimate with any precision the state revenue effects of some provisions of the new federal tax law.  Further, most of the more consequential of these provisions carry significant downside risk for state budgets.  Examples include the shift to a “territorial” corporate income tax, which likely will drive more corporate profits into overseas tax havens where they can accrue tax-free, lowering corporate tax revenue in many states.  The magnitude and timing of these effects are uncertain.  Similarly, the new federal tax code allows businesses to deduct the full cost of purchasing equipment and machinery immediately, rather than gradually over its useful life.  That change will reduce federal and state revenues in the next few years, but it’s difficult to know how much individual states will lose.  States will recoup the lost revenue in later years because companies will no longer be depreciating earlier purchases, but in the next few years, states will lose an uncertain amount of revenue.

• Behavioral responses are uncertain.  The major changes in the federal tax code likely will cause taxpayers to change their behavior to reduce their tax bills in new ways, cutting both federal and state revenue.  For instance, some workers may shift their status from “employee” to “independent contractor” to take advantage of new, lower tax rates for independent contractors organized as “pass-through” business entities.  Given the breadth of the changes, these behavioral responses could be extensive, but no one knows at this point. 
• State statutes are open to interpretation.  Sometimes, the state statute that determines whether and how particular provisions in a state’s code link to the federal code is ambiguous.  For instance, several states have statutes that could be read to require taxpayers to receive a federal personal exemption to qualify for the state’s personal exemption.  The new law’s ultimate state revenue impacts will hinge in part on how states interpret their statutes and on the results of any ensuing legal challenges.