States Grapple With Federal Tax Cut That May Raise State Taxes

By FeaturesDow Jones Newswires

State legislatures across the U.S. will be wrestling in coming months over how to respond to federal income-tax cuts that, paradoxically, could raise tax bills at the state level.

Many states typically follow the federal government's rules for deductions, exemptions and other breaks. When federal rules change, as they did under the law passed late last year, state rules often do, too.

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State lawmakers must choose whether to conform their systems to the new federal rules, cut tax rates to prevent rising tax burdens or spend potential revenue windfalls.

The outcomes will be determined in state legislative sessions now opening across the country.

"Everyone thought that tax reform was done," said Nicole Kaeding, an economist at the conservative-leaning Tax Foundation in Washington. "All we've done is move it from one capital to 50 capitals."

The new federal legislation curtailed many tax breaks, such as individual deductions for mortgage interest and tax-preparation fees and business deductions for interest and entertainment expenses. While federal rate cuts more than offset those changes, state tax rates haven't changed. So if states adopt the new, broader federal income tax base, it could mean higher state taxes for many.

New York shows one of the quandaries faced by the states. Its Department of Taxation and Finance issued a report last week estimating that the federal government's new limit on business-interest deductions would yield $45 million in tax revenue for New York. For individuals, a quirk of the way the personal exemption is written for single filers in New York could mean an $840 million tax increase, while the expanded federal child tax credit could cause a $500 million state tax cut for households with children.

"States have some difficult choices to make," said Phil Oliff, a senior manager at The Pew Charitable Trusts who tracks state fiscal policy.

Accepting federal definitions makes tax compliance easier, but states don't have to use those rules. In the past, many have rejected federal bonus-depreciation rules, which let companies deduct most of the cost of capital investments such as heavy equipment in the first year. The new federal law allows full, immediate deductions for those same purchases, and states may again choose not to incorporate the change into their state income-tax systems.

"If the states see something that's completely adverse under this new law or something that's particularly beneficial, they may choose just to take that section," said Steve Wolodychak, state and local tax practice leader at EY LLP.

State lawmakers also are wrestling with how to adjust to the federal government's decision to limit deductibility of state and local income and property taxes. That move will raise federal tax bills for some households in many high-tax states, such as New York and California. State lawmakers are exploring steps to soften that blow.

Most states and Washington, D.C. have personal and corporate income taxes, and those sources provide states with more than 40% of their revenue, according to the Census data compiled by the Federation of Tax Administrators.

The impact of federal tax changes will be smallest in states such as Wyoming and South Dakota that lack income taxes. The debates could be most complicated in divided-government states such as Minnesota and Colorado.

Colorado could get an additional $3.2 billion to $4.2 billion over the next decade, says Michael Hartman, executive director of the Department of Revenue. Democratic Gov. John Hickenlooper wants to put that money into infrastructure, education and the state's rainy-day fund. Senate President Kevin Grantham, a Republican, said the state could use added revenues to fund up to $3 billion in bonds to widen Interstates 25 and 70 and make other infrastructure investments.

As in other states, Colorado's short legislative session leaves lawmakers only so much time to make decisions.

"Whatever we figure out, we better figure out before May 9," Mr. Grantham said.

In Minnesota, Republican State Rep. Greg Davids, chairman of the House Taxes Committee, said he was trying to figure out who would pay more in state taxes, then change state law to reverse that effect so people are kept whole.

"Of course my good friend the governor has a wish list of things he wants," he said, speaking of Democratic Gov. Mark Dayton. "I want to get the money back to the people who paid it in. So we have some differences."

Asked to comment, Mr. Dayton's office deferred to the state's Department of Revenue, which says it is still studying the federal-tax law and looking forward to working with legislators.

Businesses are watching cautiously, too. As the federal corporate tax rate drops to 21% from 35%, state taxes will be an increasingly important part of corporate planning.

Write to Richard Rubin at richard.rubin@wsj.com

(END) Dow Jones Newswires

January 23, 2018 05:44 ET (10:44 GMT)

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