What Tax Reform Means for State and Local Tax and Fiscal Policy

By :: April 25th, 2012

In testimony before the Senate Committee on Finance this morning, I discussed what federal tax reform would mean for state and local governments and how Congress could help by coordinating tax law across states. Here are my opening remarks. You can find my full testimony here.

With increasing concerns about the federal deficit, fairness, and the complexity and inefficiency of our tax system, the need for fundamental federal tax reform is critical.  Often overlooked, however, is the fact that any such reforms will also affect the tax and fiscal policies of state and local governments.  Although the country’s economic condition is improving, state and local governments are still struggling to balance their budgets.  They also play an important role in our economy, running about half of all domestic public programs and with state and local spending making up about 15% of gdp.

 Decisions about changing federal policy should take into account the potential effects on state and local government budgets in both the short and the long run.

 I will make 4 points today.

 Federal tax policy and reform can help or hurt states. Federal policy affects how attractive specific taxes are for state and local governments and, therefore, how those governments organize their tax and revenue systems.  State revenue sources—especially income taxes—often piggyback on federal rules. More specifically, statutory changes in federal law can result in significant increases or decreases in state revenue. For example, state income tax revenue increased after the 1986 tax reform expanded the federal income tax base, and allowed states to also reduce their rates. In contrast, the elimination of the state and local tax deduction could increase the cost to state and local governments of providing services.

 Unstable federal tax policy trickles down to the states and uncertainty is especially problematic for state and local governments.  State and local governments are required to pass balanced budgets every year.  This requires being able to accurately forecast revenues. Problems with state tax systems are exacerbated by uncertainty in federal tax rules. Temporary extensions of credits, deductions, and tax rates complicate state forecasting. Policy changes and uncertainty can directly affect state tax bases through changing definitions of income or indirectly due to changes in taxpayer behavior.  Especially problematic has been uncertainty about future federal estate taxes and tax rates on dividends and capital gains, sources of volatile income for states

 If fundamental tax reform is undertaken, transition relief might be important for state and local governments. Tax changes can help or hurt states, but understanding the short-run effects will be important and may require slower adoption of policies or some fiscal relief.  Understanding the state of the economy and the fiscal health of state and local governments will be important.

 Due to our federalist system, Congress has a role in helping to coordinate or protect the existing state and local tax base. State and local governments’ ability to raise revenue can be hobbled by limitations that Congress could remove. Most notably, Congress could enact legislation that could help coordinate action across states and would help enable state and local governments to collect taxes on internet and mail-order sales.

Other panelists explored the costs of current federal tax preferences—the state and local tax deduction and tax-exempt municipal debt—that affect state and local governments as well as how federal legislation could help state and local governments coordinate tax policy in the face of changing technology.  The hearing was lively and a good mix of both considering long-term reform and more practical measures that Congress is more likely to act on. 

Opening statements from Senators Baucus and Hatch and the other witnesses are here.

7Comments

  1. AMTbuff  ::  2:49 am on April 26th, 2012:

    If fundamental tax reform is undertaken, transition relief might be important for state and local governments.

    I have never seen an article on tax expenditures which accounted for aid to state and local governments to backfill their losses from removal of tax breaks for state and local tax payments and for muni bond interest. Those articles implicitly, incorrectly, and in my opinion misleadingly omit the revenue sharing which is certain to be included.

    This omission is on top of the articles’ other implicit assumptions that taxpayers would not alter their decisions in the absence of current tax breaks and that tax rates would not be lowered when tax breaks are removed. All these errors operate in the same direction, giving the reader an exaggerated impression of the revenue gain from reducing tax breaks.

    If there ever is a grand bargain to reduce tax expenditures, I predict that the revenue increase will fall more than 50% below proponents’ estimates. Furthermore the shift in tax policy will disrupt the economy for a year or two. That’s why tax reform is best done when the economy is healthy.

  2. Vivian Darkbloom  ::  3:37 am on April 26th, 2012:

    AMT,

    Kim Rueben’s post also points out that states may stand to gain revenue from eliminating or reducing tax expenditures. Because states often “piggy back” on federal income tax law, state politicians would not necessarily need to do anything to raise additional state revenue. Of course, whether net revenue is raised depends on the type of tax expenditures involved. States would stand to gain, not lose, revenue if the mortgage interest deduction would be phased out.

    I also think revenue losses (or the effect on deficits) is overstated if Congress were to curtail federal deductions for state and local taxes and/or the exclusion for municipal bond interest. With respect to municipal bond interest, the effect would be drive up borrowing rates. However, the biggest problem states have are existing payrolls unfunded liabilities for benefits. Muni bonds don’t finance those things. States may need to cut back on future spending for infrastructure projects. Depending on what the money might be spent on, this is not a good thing, but it might encourage more prudent spending choices (no multi-billion rail projects for California?).

    As far as state taxes are concerned, I don’t see the direct connection between the feds eliminating or reducing the deduction and a loss of state revenues. Like mortgage interest, state *real estate* taxes are frequently deductible at the state level even though state *income taxes* are not. Persons will likely cut back on purchases of muni bonds, but how does one voluntarily cut back on paying state taxes? Move to another state? If so, this is one state’s loss and another state’s gain.

    The recent need for federal subsidies had nothing to do with the tax code per se, but to do with the weak economy. And, the elephant in the room was, and still is, the state and local public employee unions. Even if federal “tax reform” would have the effect of reducing, on net, state revenues, a reasonable alternative would be to reduce state obligations benefitting this group rather than making a political choice to mollify them.

    I agree that estimates of the amount of money to be raised at the federal level for tax expenditures is likely overstated. However, I fail to see why “tax reform”, per se, is better done when the economy is healthy. The term “tax reform”, like “tax loophole” is used here correctly only in the breach. In practice “tax reform” is used to justify agendas that either 1) raise additional revenue through tax increases (including tax expenditure cuts); or 2) reduce revenues through tax cuts (or tax expenditure increases). The true meaning is to “improve” or “make better” the tax code. There is no better time to do this than when the economy is weak.

  3. Michael Bindner  ::  2:01 pm on April 29th, 2012:

    I also submitted comments on this topic to Senate Finance. I will post them below.

  4. Michael Bindner  ::  2:03 pm on April 29th, 2012:

    Chairman Baucus and Ranking Member Hatch, thank you for the opportunity to submit these comments for the record to the Senate Finance Committee. As always, our comments are in the context of our four part tax reform plan:
    · A Value Added Tax (VAT) to fund domestic military spending and domestic discretionary spending with a rate between 10% and 13%, which makes sure very American pays something.
    · Personal income surtaxes on joint and widowed filers with net annual incomes of $100,000 and single filers earning $50,000 per year to fund net interest payments, debt retirement and overseas and strategic military spending and other international spending, with graduated rates between 5% and 25% in either 5% or 10% increments. Heirs would also pay taxes on distributions from estates, but not the assets themselves, with distributions from sales to a qualified ESOP continuing to be exempt.
    · Employee contributions to Old Age and Survivors Insurance (OASI) with a lower income cap, which allows for lower payment levels to wealthier retirees without making bend points more progressive.
    · A VAT-like Net Business Receipts Tax (NBRT), which is essentially a subtraction VAT with additional tax expenditures for family support, health care and the private delivery of governmental services, to fund entitlement spending and replace income tax filing for most people (including people who file without paying), the corporate income tax, business tax filing through individual income taxes and the employer contribution to OASI, all payroll taxes for hospital insurance, disability insurance, unemployment insurance and survivors under age 60.
    Our proposals have several impacts on state and local tax and fiscal policy. Those states with fixed conformity provisions regarding income taxation in law or their constitutions will be greatly affected by enactment of a simplified income tax which treats distributions from inheritance as normal income. Indeed, if they do not enact similar reform, which includes a much higher income floor for filing, many more heirs will be touched by this provision than in federal law. As most state income tax rate structures are much less progressive than the federal system, many states will be able to abandon income taxation altogether, possibly increasing use of Land Value Taxes if some form of redistributive tax is still desired.

    If the basic structure of reform is adopted in the states, the biggest change will be the need for a common base between federal and state consumption taxes. Shifting from retail sales taxes and gross receipts taxes to value added taxes and VAT-like net business receipts taxes will change the nature of most state taxation, while enabling ease of collection of taxes on online sales, since taxes would be levied at every stage of the production process.

    If a common base agreement can be negotiated for these taxes, state treasurers can collect both their own taxes and the federal taxes, as well as analytical information on tax credit usage, which can then be shared with the U.S. Internal Revenue Service in order to track income accruing to payers of the federal high income surtax, as well as to recipients of the federal child tax credit, which would be paid to employees with wages under the NBRT and then verified by a mailing from both the employer and the Internal Revenue Service, with employees verifying that their employees paid every dollar to them reported as a credit.

    Our hope is that states would match the Child Tax Credit at a level consistent with their cost of living. Some states might even include higher credits for certain high-cost counties, for instance, Northern Virginia.

    The NBRT at both the state and federal levels should fund services to families, including education at all levels, mental health care, disability benefits, Temporary Aid to Needy Families, Supplemental Nutrition Assistance, Medicare and Medicaid. If society acts compassionately to prisoners and shifts from punishment to treatment for mentally ill and addicted offenders, funding for these services would be from the NBRT rather than the VAT.

    States may also include several of the educational and social service credits recommended under our proposal. The NBRT could be used to shift governmental spending from public agencies to private providers without any involvement by the government – especially if the several states adopted an identical tax structure. Either employers as donors or workers as recipients could designate that revenues that would otherwise be collected for public schools would instead fund the public or private school of their choice. Private mental health providers could be preferred on the same basis over public mental health institutions. This is a feature that is impossible with the FairTax or a VAT alone.

    To extract health care cost savings under the NBRT, allow companies to offer services privately to both employees and retirees in exchange for a substantial tax benefit, provided that services are at least as generous as the current programs. Employers who fund catastrophic care would get an even higher benefit, with the proviso that any care so provided be superior to the care available through Medicaid. Making employers responsible for most costs and for all cost savings allows them to use some market power to get lower rates, but not so much that the free market is destroyed. Increasing Part B and Part D premiums also makes it more likely that an employer-based system will be supported by retirees.

    Enacting the NBRT is probably the most promising way to decrease health care costs from their current upward spiral – as employers who would be financially responsible for this care through taxes would have a real incentive to limit spending in a way that individual taxpayers simply do not have the means or incentive to exercise. While not all employers would participate, those who do would dramatically alter the market. In addition, a kind of beneficiary exchange could be established so that participating employers might trade credits for the funding of former employees who retired elsewhere, so that no one must pay unduly for the medical costs of workers who spent the majority of their careers in the service of other employers.

    Conceivably, NBRT offsets could exceed revenue. In this case, employers would receive a VAT credit.

    There will be no impact on the states of FICA reforms, except to the extent that our suggested reforms yield a higher base benefit for seniors, which will decrease their need for state social service benefits.

    Income tax simplification will eliminate the deduction for state income and property taxes. The extent to which state income taxes are eliminated will also eliminate the demand for these, although if states adopt higher land value taxes for redistributive purposes, some residual deduction for this tax may need to be included in the federal tax code, although doing so will simply require higher federal rates to make up the difference. Additionally, abandonment of the state income tax deduction has been seen as a reason to entirely federalize Medicaid as an offset. Doing so may be appropriate, however if participants in subsidized and paid adult education are covered by the provider’s insurance as if employees and retirees long term care needs are increasingly covered by the firms they retired from as an offset to Net Business Receipts Taxes, the question of funding Medicaid may be a minor footnote.

    Thank you for the opportunity to address the committee. We are, of course, available for direct testimony or to answer questions by members and staff.

  5. aslam  ::  12:31 pm on May 17th, 2012:

    Taxpolicycenter is a great blog.This content is very informative.Hei Kim Rueben, your post”Means for State and Local Tax and Fiscal Policy”is undoubtedly exact.

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