States should immediately decouple from four costly corporate tax provisions in the new federal tax law: bonus depreciation, immediate expensing for research and development, relaxed interest deduction caps, and the foreign-derived intangible income deduction. Were states to conform to these four, they would lose billions of dollars in revenue that otherwise could fund education, health care, and other services. Lost revenue would largely subsidize corporate investments in other states.
For states that automatically conform to federal tax law, the window to act is closing fast, because many of these provisions have already taken effect. But states can protect themselves. Michigan, for example, has already acted to protect an estimated $540 million in a single year by decoupling from just three of these provisions.
Business Tax Conformity: High Cost, Tiny Benefits
State taxes on business income – that is, their corporate income taxes, and to a lesser degree their individual income taxes – are based on federal tax rules. Some states automatically adopt federal tax law changes as they occur. These are the states that are in the most danger right now. Other states conform to federal law as of a specific date, but they too may be in danger of needlessly updating to include the provisions of the new federal law.
Regardless of opinions about the new federal tax rules at the national level, they are not good policy at the state level. That’s because states tax a share of the nationwide profit of multistate corporations. They calculate corporate taxes by:
- Taking the company’s nationwide gross receipts,
- Subtracting nationwide deductions, and
- Taxing the state’s share of that nationwide profit.
Consequently, when states fail to decouple from federal tax breaks, they may be giving up desperately needed revenue to subsidize investment, research, and other activities that occur largely or even entirely in other states, providing little if any benefit to their own economies.
Four Priority Provisions for Decoupling
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Bonus Depreciation (Sections 70301 and 70307 of the federal law)
Probably the most expensive feature of the new federal law for states is the restoration and expansion of a provision known as 100 percent bonus depreciation.
This rule allows businesses to write off the full cost of machinery and equipment in the first year they are placed in service, rather than spreading that cost over the useful life of the asset. It also provides a new temporary 100 percent write-off for manufacturing plants. What this means is that a highly profitable corporation can make it appear that it does not have any taxable profits at all, so long as it is buying up equipment and building factories. In other words, rather than spreading out the deduction over assets’ useful lives, bonus depreciation bunches all deductions into year one, creating a massive upfront tax break.
Fortunately, most states have already decoupled from previous rounds of bonus depreciation due to cost and the out-of-state benefit problem. All states should now decouple from both provisions.
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Research and Development Expenses (Section 70302 of the federal law)
OBBBA restores a previous law that allowed immediate write-off of research and development expenses, reversing a 2017 provision that required five-year amortization. It also allows retroactive write-offs back to 2022 for smaller businesses.
The five-year approach makes sense because R&D investments pay off over multiple years. Immediate expensing doesn’t match economic reality. The retroactive provision, in particular, is pure windfall, because you can’t incentivize investments that already happened. All states should retain the five-year write-off and reject retroactivity.
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Interest Deductibility Cap (Section 70303 of the federal law)
OBBBA loosens the cap on how much interest on loans can be deducted. The 2017 tax law imposed a cap on the ability of large corporations to deduct interest on their bonds and other debt, limiting the deduction to 30 percent of taxable income. A 2021 law made a technical change in how that taxable income for purposes of the cap was calculated, and it had the effect of tightening the limit, but OBBBA restores the looser limit. This is a problem because limits on interest deductibility help prevent corporations from excessively leveraging debt to reduce their tax bills – a hallmark of private equity deals in particular.
Those states that coupled to the tighter limit should retain it, and other states that never conformed to the 30 percent limit should start doing so.
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Foreign-Derived Deduction Eligible Income (FDDEI) (Sections 70321 and 70322 of the federal law)
OBBBA preserves with slight modifications (and renames) a special deduction for profits deemed attributable to foreign sales of goods and services that incorporate U.S.-held intellectual property like patents and trademarks. This provision taxes this income well below the standard corporate rate.
This provision has proven far more costly than originally estimated. There’s no guarantee that R&D, marketing, or management of intangibles incentivized by the FDDEI provision will occur in any particular state, yet coupled states lose revenue regardless. Colorado has already acted to decouple, and all other states not already decoupled from FDDEI should do so immediately.
What Else States Should Do Now
Each state revenue department should immediately inform policymakers and the public which OBBBA provisions it conforms to on a provision-by-provision basis. Many states have already published such reports. States should also produce estimates of revenue loss from coupling (or revenue gain from decoupling).
The Bottom Line
States face balanced budget requirements and are dealing with deep cuts in federal funding for programs like Medicaid and food assistance. They simply cannot afford to give away hundreds of millions in revenue to subsidize corporate spending that may occur entirely outside their borders and likely would occur anyway.
The silver lining in OBBBA’s passage is that it creates an opportunity for states to be thoughtful about tax conformity and steer policy in a direction that better reflects the will of their residents—particularly since overwhelming majorities of Americans believe both corporations and the wealthy pay too little in taxes, not too much.
As we explained in more detail in a recent webinar, states should prioritize decoupling from these four provisions as quickly as possible, and also decouple from or avoid conforming to other unproductive provisions of the new federal tax bill, to protect their revenue bases and ensure their tax policies support their own residents and economies.
