State Governments

Another Winner From Tax Reform: State Governments

Taxpayers could end up sending hundreds of millions of dollars more to state treasuries as a result of slashing federal deductions and exemptions.


John Greim John Greim Photography/Newscom

During a dinner in December 1974 at the Washington Hotel, so the story goes, Authur Laffer sketched a curved line on a cocktail napkin to demonstrate to Donald Rumsfeld how cutting tax rates could actually increase tax revenue.

The basic idea imparted to Rumsfeld, chief of staff for then-President Gerald Ford, (and other Republicans attending dinner that night) would serve as the basis for nearly every GOP-backed tax proposal since—including the Tax Cuts And Jobs Act, signed into law by President Donald Trump on Friday.

The so-called "Laffer Curve" makes a solid, important argument for reducing tax rates and letting Americans keep more of their own money. As a practical matter, it lets Republican lawmakers have their cake and eat it, too, by promising economic growth, fatter worker paychecks and more government revenue. It doesn't always work out. No matter how much Republicans wish for the Economic Growth Fairy, not a single analysis of the Tax Cuts And Jobs Act projects that economic growth will cancel out the $1.5 trillion in tax cuts included in the bill.

The impact at state capitols, though, could be quite different. In all, states figure to be one of the big winners from federal tax reform—they stand to collect a windfall of cash without having to make any change in their own policies. Some state policymakers are already figuring out what to do with that bounty. In some places, that will be an added dose of good news for taxpayers.

The passage of federal tax reform could mean an increase of between $150 million and $200 million annually in state revenue in Oregon, state economist Mark McMullen told the Oregon Senate Committee on Revenue and Finance earlier this month. And they are in line with what is being seen in other states.

"These are big numbers, and catching our attention," McMullen said. "In the past, when we've seen big federal changes to tax law—in the Reagan era and the Bush tax cuts—both of those turned into real significant boosts in terms of Oregon's own source of revenue."

The same is true in Maryland, where Gov. Larry Hogan's administration expects state tax revenues to increase by "hundreds of millions of dollars a year," according to The Baltimore Sun.

The relationship between federal taxes and state tax revenue can't quite be reproduced on the back of a cocktail napkin, but the correlation is a strong one.

Taxpayers in 36 states begin their state returns with their federal gross or taxable income, says Joseph Bishop-Henchman, vice president of the Tax Foundation, a tax policy think tank based in Washington, D.C. Nine states have no income tax, leaving just a handful of states with no direct connection to the federal tax code.

The changes wrought by the federal tax bill generally broaden the income tax base by eliminating or reducing deductions for individuals and businesses. Eliminating those exemptions and deductions at the federal level will increase taxable income amounts. Unless states follow suit by reducing their tax rates, the result will be a larger level of taxable income for state-level taxpayers, McMullen says.

An expanded corporate tax base and one-time repatriation (under the federal tax reform, corporations can pay a one-time tax to bring $2.6 trillion in overseas assets) will also boost state tax revenues as those assets suddenly reappear on businesses' tax returns.

"States will receive a windfall from this, although it will be uneven based on where international companies have state tax liability," Henchman says.

Doubling the standard deduction will also impact states. Twelve states conform with the federal standard deduction, and will see lower revenue as a consequence and 10 states have a personal exemption eliminated entirely in the federal tax bill, so is a net wash for the most part, says Henchman.

And what about the much-discussed reduction of the state and local tax (SALT) deduction in the federal tax code? Taxpayers in high-tax states will be allowed to deduct only $10,000 for property, income, and sales taxes on their federal return.

That means some taxpayers in those high tax states will see a larger federal tax bill in future years, but the change will not affect state revenues at all. In fact, if the loss of the SALT deduction encourages more taxpayers to take the standard deduction instead of itemizing deductions, it may tip a little more revenue into state coffers, The Tax Foundation estimates.

Hogan, a Republican, has called for changes to state policy to prevent residents of Maryland (one of those high-tax states where taxpayers will get whacked by the elimination of the SALT deduction) from facing higher tax bills. Hogan has not yet released a detailed proposal, but he told the Sun last week that his proposal would return to taxpayers any additional state revenue received as a result of the loss of federal deductions and exemptions. A formal proposal to the state legislature is expected in January.

In Iowa, Senate Republicans and the state Treasury Department are reportedly crafting a proposal to overhaul the state tax code by reducing the number of tax brackets and expanding the state sales tax base. The proposal would rely on increased state tax revenue from the federal tax changes to offset state tax reform.

Most states are still assessing how federal tax reform will affect their bottom lines and their taxpayers' wallets. Still, for all it's drawbacks, the federal tax changes passed this year could set-off a string of policy changes at the state level that will benefit taxpayers—or, at the very least, keep more of their tax dollars in state capitols, as opposed to being sent to Washington, D.C.