The new Trump tax plan would rob states of revenues they need to serve their residents at a time when states already face significant fiscal distress, with over half of them projecting budget shortfalls for fiscal year 2018. And it would add to the problems caused by the President’s proposed cuts next year in funding for important state and local services, as well as congressional proposals to shift large health care costs to the states by repealing the Affordable Care Act and sharply cutting federal Medicaid spending.
Several parts of the Trump tax plan would affect state revenues:
The deduction gives taxpayers who itemize a discount from the federal government for the state and local taxes they pay. That’s particularly important in states with higher and more progressive income taxes. Without that deduction, many of these taxpayers would likely demand less progressive state income taxes and/or tax cuts. They also may be less likely to support the tax increases that other parts of the Administration’s agenda may force upon states in order to maintain their residents’ quality of life.
At 15 percent under the Trump plan, the tax rate on pass-through income would be 20 percentage points below the Trump plan’s top tax rate on wages and salaries, creating a strong incentive for many wage earners to reclassify their wages as pass-through income by turning themselves into pass-through businesses for tax purposes. That could mean major revenue losses for the handful of states that don’t tax income from pass-through businesses or tax it at a lower rate than wages and salaries. (Conservative governors and lawmakers in some other states have considered creating a lower tax rate or providing other preferential tax treatment for pass-through income.) While the Administration claims it would create safeguards to prevent this gaming, such safeguards might well prove ineffective in the face of such a large tax-rate differential between ordinary and pass-through income.
This new system would encourage corporations to invest and book profits overseas and to use various forms of “transfer pricing” (transactions between a parent company and its foreign subsidiaries) to make it appear that they actually earned their U.S.-based profits overseas. Most states base their corporate taxes on the federal tax and, thus, these practices by U.S.-based multinationals would reduce state as well as federal corporate tax revenues.
Treasury Secretary Steven Mnuchin has said that “We want to get the federal government out of the business of what’s the states’ business.” But states aren’t alien creatures with a different agenda than the federal government. The principle of federalism implies a partnership between the federal government and the states to provide for the public welfare. By weakening states’ ability to provide for their residents, the Trump tax plan could undermine that partnership.