Watch Out -- Here's Why Tax Reform Could Give You a Nasty Shock Next April

With the passage of the tax reform measures late last year, many taxpayers are looking forward to seeing some savings when they file their 2018 tax returns early next year. Yet one effect of tax reform at the federal level went largely unnoticed, and the impact could be huge.

Even as policymakers scurry to figure out how to avoid any of the potentially negative consequences, there's no guarantee that everything in this area will work the way it has in the past. That could give taxpayers a nasty surprise when they sit down to do their taxes next year.

The issue has to do with the way that many states have structured their own income tax systems. To the extent that a state relies on federal law to define key elements of how residents calculate and determine what they owe in state and local income taxes, tax reform could have wrought unanticipated changes to things that state and local governments had previously taken for granted. As this report from the Tax Foundation notes, the fallout could require major overhauls of state tax systems in order to avoid losses of revenue and other undesirable results.

The root of the problem

To understand the issues that states face, it's important to understand the ways that various states piggyback on federal tax law. Often, states will have the same definitions as federal tax laws for key terms like adjusted gross income or taxable income. Some also require consistent treatment of taxes across federal and state lines in areas like filing status and whether you take the standard deduction or itemize your deductions. When everything works well, that can simplify things for taxpayers, as it avoids having to use two completely different sets of rules to calculate tax liability for federal and state purposes.

The problem is that various states use different methods of conforming their tax law provisions to federal law, and not all of them are automatic. Many states make specific references to current law, meaning that reform automatically changes their provisions, as well.

But some states use federal tax law as of a certain date in the past, and any subsequent changes have to be specifically authorized by state lawmakers. That can lead to difficult situations when major changes occur, such as the elimination of certain deductions and exemptions or major shifts in tax rates. Michigan makes it even more complicated, as taxpayers can choose either current law or the law that was in effect as of 2012.

At the federal level, tax reform included give and take as part of a relatively balanced package. Yet depending on the way a particular state structures its tax system, it's possible that only some changes will take effect while leaving offsetting provisions excluded. If that happens, there'll be implications for how much in taxes a state collects.

What it means for states

In particular, there are two situations that are most likely to come up. One involves the calculation of adjusted gross income or taxable income for state purposes. If a state uses federal adjusted gross income, but then has its own provisions for coming up with taxable income from there, then the increase to the standard deduction and the elimination of personal exemptions at the federal level won't necessarily have any impact on the state's subsequent calculation of its own taxable income. However, if a state uses federal taxable income as its starting point, then those federal changes will automatically flow through to the state's taxable income, as well. The Tax Foundation argues that states that use current law will likely see higher taxable income than those that don't.

The other situation has to do with itemizing versus taking the standard deduction. Some states force taxpayers to use the same method on their state taxes that they do federally, taking away the right to itemize for state purposes if you take the standard deduction on your federal return. With a higher standard deduction, fewer people will itemize, and that could result in fewer people itemizing on their state returns, as well -- with corresponding upward impacts on state taxes.

States therefore must look at whether to capture the opportunity to boost their tax revenue by conforming to a more inclusive definition of taxable income under new federal law. Those that want to avoid what could otherwise be an automatic tax increase for residents will need to take action either to forestall conforming their state tax laws to their federal counterparts or consider offsetting tax cuts in other areas.

Keep your eyes on your state capital

Unless you're fortunate enough to live in a state without income tax, you'll need to take this tax reform-related issue to heart as you do your tax planning for 2018. Depending on where you live, you could get a shock when tax season rolls around early next year.

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