What to Watch in the States: State-Federal Relationship Shifting

February 28, 2017

Dylan Grundman O'Neill
Senior Policy Analyst

So far in this series on tax policy topics to watch in 2017, we’ve covered important state debates in areas such as attempts to weaken or eliminate progressive taxes and needed updates to gas taxes and sales taxes. As if those topics weren’t enough to keep state lawmakers up at night, they will be making these decisions amid a great deal of uncertainty about the future of federal tax and funding policies that are crucial to the states. How those federal debates shake out, and how states prepare for and react to them, will have lasting consequences for families and businesses in every state, and for the very nature of federalism in the United States.

The first example of this is the very high likelihood of reduced federal funding for aid to states and for services such as health care, K-12 schools, and higher education that have historically been provided through a mix of local, state, and federal efforts. Many states are preparing two-year budgets right now with no clear idea of what to expect from Congress. For example, Governing has noted that states are underprepared for the ramifications of federal retrenchment in healthcare. Details are hazy but with leading federal budget proposals taking major cuts as a given – including the possible block-granting of Medicaid and other programs, repeal of the Affordable Care Act, and even completely eliminating the Department of Education – congressional representatives are sending the clear message that they intend to pull back drastically on their portion of those shared investments.

State leaders will have to decide whether they value their residents’ education, health, and safety enough to step up to these challenges as the federal government backs down from them. Stepping up will require replacing lost federal dollars with new state revenues, which will be particularly hard in states where legislators have been attempting for years to slash taxes and cut back on their share of these investments.

And that’s just the spending side of the federal budget. Federal tax changes could have serious impacts on the states as well.

Tax plans laid out by President Trump and congressional leadership include a number of provisions that could impact the states. Ending the deductibility of state and local taxes, creating a new deduction for child care expenses, changing the taxation of carried interest, altering expensing of business investments, and other corporate tax changes such as “border adjustment” could all have ripple effects on state revenue systems.

Another key example is the estate tax. In the 2000s, as federal tax cuts greatly weakened the federal estate tax and eliminated a credit for state estate taxes that was the basis for most such taxes, states had to decide whether to “decouple” from these changes and preserve their role in promoting equality of opportunity and resisting the growing influence of inherited wealth. Most states declined to act and today only 14 states and the District of Columbia have estate taxes. But in many of those states, a relationship between the state and federal tax estate tax codes remains, as exemption levels and other parameters often remain coupled to federal statute. Should Congress decide in the coming years to fully eliminate the federal estate tax or weaken it further, as both President Trump and congressional Republicans have indicated a desire to do, these states would again find themselves having to choose whether to passively accept such changes to their own tax codes or take action to establish a truly independent estate tax.

Similar “decoupling” questions could face states in respect to multiple other federal tax policies. One example to watch is federal treatment of capital gains interest and dividend income. Speaker Ryan has expressed a desire to exclude 50 percent of this income from federal Adjusted Gross Income (AGI), while another approach with a similar effect would be to simply reduce the tax rate on this income. However, if such a cut is enacted in the form of an exclusion from AGI, state revenues would suffer because many states use federal AGI as the starting point for their own income calculations. A rate cut would not ripple down to states in the same way. State lawmakers and advocates should watch such debates closely so they can either decouple from provisions where they are vulnerable to federal changes or encourage their federal representatives to reconsider the policies or adopt a different approach that does not harm the states. States with “rolling” conformity to the federal tax code could also consider switching to “fixed date” conformity to reduce their vulnerability to such changes.

Another approach some states are taking to proactively address some of these issues is to pass bills that automatically decouple from federal tax changes that significantly threaten state revenues. A thoughtful bill introduced in Nebraska, for example, preempts the adoption of any federal changes to the calculation of AGI that reduce Nebraska revenues by more than $5 million and requires a report to be produced on such changes so that lawmakers can make an informed and deliberate decision on whether to couple to the policy.

Other federal changes could increase revenues in some states. A few states still have an ill-advised state deduction for federal income taxes, which means that federal income tax cuts would reduce the size of that deduction and thereby increase state revenues. And if federal tax changes broaden the tax base by limiting itemized deductions, for example, states that couple to those income calculations will see revenue gains as well. In these cases, states may be tempted to “pass on” the benefit to their residents in the form of tax cuts, but it will be important for them to think twice about such tax cuts given the likely federal funding cuts summarized above and the need in many states to build up reserves before the next recession hits.