Trump Tax Plan Would Make States’ Job Still Harder

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:

• Repealing the federal estate tax. Fourteen states plus the District of Columbia levy their own estate tax, raising roughly $3 billion a year. All but two depend on federal rules and forms for administering their estate tax and would find it extremely hard to maintain the tax if the federal tax were repealed: Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New York, Oregon, Rhode Island, Vermont, and the District of Columbia. Eliminating state estate taxes would enrich a handful of wealthy families at the expense of resources for schools, roads, health care, and other building blocks of thriving communities.
• Eliminating the deduction for state and local taxes. Taxpayers who itemize deductions on their federal income tax returns can deduct state and local property taxes, as well as either state and local income taxes or general sales taxes. State and local taxes have been deductible since the federal income tax was created in 1913, on the theory that income paid in state and local taxes is not disposable income, so taxing it at the federal level is double taxation.

  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.

• Setting a special, lower rate on pass-through income. Pass-through income — income from businesses such as partnerships, S corporations, and sole proprietorships that’s currently taxed at the same rates as wages and salaries — is heavily concentrated among wealthy investors. Cutting federal income tax rates for these businesses could have an indirect, adverse effect on state revenue.

  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.

• Repealing the Alternative Minimum Tax (AMT). President Nixon and Congress created the federal AMT in 1969 to prevent the highest-income households from eliminating most if not all of their federal income tax liability by exploiting loopholes, exclusions, and deductions. The AMT mainly affects higher-income households, with over 60 percent of taxpayers with incomes between $500,000 and $1 million paying additional tax because of it. While there are ways to reform or improve the AMT, repeal would create opportunities for tax avoidance. Three states (Colorado, Connecticut, and Wisconsin) use the federal AMT as the basis for their own minimum tax. If federal policymakers repeal the federal AMT, states would have to create their own AMT or stop levying the tax.
• Adopting a territorial corporate tax system. U.S.-based multinational companies must pay U.S. tax on their profits, no matter where in the world they earn them, but their overseas profits aren’t taxed until the multinationals bring them back to the United States and companies get credit for the taxes they pay to other countries. Under the Trump tax plan, in contrast, only the profits that those multinationals earn in the United States would be taxed — and the federal government would never tax the profits that those companies earn overseas.

  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.