Most states use the federal tax code as a starting point for their calculations of state personal income taxes, corporate income taxes, and estate taxes.
Changes to the federal code and federal tax administration have the potential to affect state tax systems enormously, but to some extent states can pick and choose which of those federal changes to accept.
States conform to the federal tax code because doing so can make tax calculations both simpler and easier to enforce. For example, in the personal income tax, state taxpayers often start their calculations from federal adjusted gross income (AGI) rather than calculating income from scratch.
Some states use rolling conformity, in which they automatically adopt federal tax changes as they occur. This approach keeps state and federal tax treatments aligned but can create unpredictability in people’s taxes and state revenues when federal tax laws change.
Other states use fixed-date conformity, in which they conform to the federal tax code as of a specific date. When federal laws change, these states must actively decide whether to adopt the new provisions. If the federal changes are relatively minor and technical in nature, then updating the state tax code to conform to them may be perfunctory. But larger changes will merit more scrutiny.
One result of conformity is that if the federal government chooses to exempt certain income from AGI, a state that conforms to the federal definition of AGI will lose revenue unless it decouples. Decoupling would mean requiring taxpayers to add back the exempt income for purposes of state tax calculations. Similarly, if a state couples to a federal provision that benefits a particular group of people – e.g. a credit for working-class families with children or special treatment for wealthy households with passive income – the effects on those people of any federal changes to those provisions can be amplified by state conformity.
Whether conformity is rolling or static, states can decide which federal provisions to adopt. Most follow federal definitions for some items while maintaining independent rules for others, and states vary as to which ones they conform to. Choosing to ignore a federal provision is known as “decoupling,” and it is particularly common when the federal government enacts a tax break that narrows the tax base and therefore would cost states revenue.
Do States and Their Residents Benefit from Tax Conformity?
On core questions such as what is taxable income or how assets should be valued for the estate tax, there are practical reasons for conformity. If the rules are mostly the same, then taxpayers have fewer calculations to make. And if the federal Internal Revenue Service – which has greater enforcement resources than states – determines that a taxpayer (for example) has underreported their income to evade taxes, this information is automatically conveyed to the state tax authority, who can use that information to straightforwardly determine whether the taxpayer owes more state taxes as well.
The downside of conformity is that it sometimes forces a state into policy decisions it doesn’t agree with. That’s why, for example, states with estate taxes generally conform to federal rules on what’s included in an estate, but most have chosen not to go along with federal increases in exemption amounts. Decoupling has allowed states to avoid providing new, state-funded tax cuts for very wealthy estates even as the federal government has done so.
Rolling conformity can place state policymakers in a politically awkward position when the federal government cuts taxes in a way that reduces revenue: Either they accept the federal change and lose revenue automatically, or they decouple – creating the appearance that they are raising taxes even if the effect is simply to remain static.
One state, Maryland, has a unique solution to the threat of losing revenue due to federal action. Maryland automatically conforms to most federal changes if the revenue implications are minor but places a one-year hold on federal changes that would cost the state more than $5 million. This approach gives the legislature time to decide whether to conform.
Related Entries
How Do State and Local Personal Income Taxes Work?
The personal income tax funds public education, health care, public safety, and other public services provided by state and local governments. If well-designed, it is the fairest major revenue source available to states.
How Do State Corporate Income Taxes Work?
A robust corporate income tax ensures that profitable corporations help fund the public services they benefit from, just as working people do. It’s one of the few progressive taxes available to state policymakers.
How Do State Estate and Inheritance Taxes Work?
Estate and inheritance taxes are taxes on wealth passed on after someone’s death. They are a common way for states to tax the inheritances of wealthy individuals. These taxes ensure that those very large estates help pay for public services like schools, hospitals, and parks.
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- Comptroller of Maryland. “Maryland Tax Alert 07-24.” July 2020.
