States Face Fiscal Consequences if Bush-Era Tax Cuts Expire

As Congress debates whether to let tax cuts passed during the Bush administration expire, there’s a lot of talk about how the decision would impact the federal budget deficit. But there are fiscal implications for many states riding on the decision, as well.

In more than a dozen states, tax codes are intertwined with federal laws in complex ways that could force state revenues up or down, depending on the state. The precise outcome depends on whether Congress decides to extend all of the tax cuts, just some of them, or none at all.

If all of the tax cuts are extended, then states wouldn’t see a change from their current fiscal footing. But if some portion of the cuts is allowed to expire as planned on December 31, then state legislatures next year may find themselves in a debate that mirrors the one going on in Washington today: How much of a burden should taxpayers shoulder during a fragile economic recovery?

“It’s going to give them decisions to make,” says Verenda Smith of the Federation of Tax Administrators, a nonprofit that represents state tax-collection agencies. Interviews with tax officials in several states suggest that states are monitoring the debate in Washington but for the most part haven’t projected the potential downsides or upsides of the various scenarios Congress is considering.

One set of calculations has to do with the estate tax, which was phased out by the Bush tax cuts. Early last decade, states that wanted to keep their own estate taxes took action to “decouple” them from the federal tax. If the federal provision expires, states would see additional revenue; they may also look at recoupling to the federal code.

Other direct fiscal impacts put states into two groups.

The first group stands to gain revenue if some or all of the tax cuts expire. This group includes nine states: Idaho, Minnesota, North Carolina, North Dakota, Oregon, South Carolina, Utah and Vermont. These states collect state taxes based on federal taxable income, as opposed to adjusted gross income. If the tax cuts expire, some increased deductions would go away and taxpayers would see their federal taxable incomes go up — and in these nine states, people would pay more in state taxes, as well.

Were that to happen, these states would have to decide if they want to keep the windfall. They could make adjustments that would give the extra revenue back to taxpayers. But most of these states are running big budget deficits, and keeping things put would allow them to raise revenues without legislators having to vote on a tax increase.

Dan John, tax policy supervisor for the Idaho Tax Commission, says there would be another reason for the state to simply go along with whatever Congress decides: simplicity. Forcing taxpayers to wade through a state tax code that differs drastically from the IRS code is quite complicated, he says.

The second group of states stands to lose revenue if some or all of the Bush tax cuts expire. These states allow taxpayers to deduct federal taxes paid from their state tax liability. So when federal taxes go up, state revenues will go down. Eight states are in this group — Alabama, Iowa, Louisiana, Missouri, Montana, North Dakota, Oklahoma and Oregon — although North Dakota and Oregon fall into both groups, so some of the impacts potentially may offset each other.

Again, states would have the option of making adjustments to make their budgets whole — namely, they could reduce the deduction for federal taxes paid. But that change would be politically difficult. Legislators voting for it could be seen as endorsing a move to piggyback a state tax hike on top of a federal one.

States have done it before, however. In Oregon, Steve Purkeypile, personal income tax policy coordinator for the Department of Revenue, says the Legislature has taken steps in the past to disconnect the state from increased federal deductions. In fact, Oregon did so to adjust to some provisions of the federal stimulus law.

‘It affects all of us’

Fong points out a return of the so-called “marriage penalty” as something he’d like to avoid. If the Bush tax cuts expire, the standard deduction for married people would decrease and their federal taxable income would increase. The result for more than 83,000 North Dakotans would be not just higher federal taxes but also state taxes that would increase by up to per year. State tax revenues would rise by .7 million per biennium.

Yesterday (September 14), Fong announced that he is working with state legislators on a contingency plan. They are writing a bill for the 2011 legislative session that would undo that state-level impact — and possibly others — in the event that Congress lets the Bush tax cuts expire.

Fong says the uncertainty of the situation — which Congress may not resolve until after November’s elections — could harm the state’s economy as consumers and business owners wonder what their tax picture will look like.