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How would federal tax reform affect the states?

Fifty directions of tax reform

In this edition of Board Briefs, board members of State Tax Notes were asked to weigh in on how they believe federal tax reform will affect the states. Valerie C. Dickerson, a Tax partner and leader of Deloitte’s Washington National Tax-Multistate practice, provides her insight on state tax matters. This article was originally published in State Tax Notes, Board Briefs, April 3, 2017.

Fifty directions of tax reform

​I like to joke with my federal colleagues that there are no fewer than 50 directions the states could take with tax reform.

While I would expect that ultimately a significant majority of states will conform to any tax reform enacted by Congress, the degree of conformity may vary widely depending on the anticipated budget impact in each state. For instance, a hypothetical state that is a heavy export base may resist any type of income exclusion for exports, if adopted. Similarly, states with capital concentrations may refuse to conform to full expensing if this is perceived as too expensive.

As a result, we may see broad decoupling from such provisions despite other base-broadening measures in place. We have witnessed similar decoupling across the state landscape before, notably relative to bonus depreciation, and it is not unreasonable to expect it here. This time around, the principal business composition within the state may well become one of the policy decision drivers of the degree of acceptable conformity.

Of course, if nonconformity were to become a prevailing theme in any particular state, I could see a desire by some lawmakers to move to a gross receipts tax for apparent greater simplicity and stability. Yet the more likely path—or at least a perceived less burdensome path in the short term—may be to freeze conformity for a year or so in order to see how the federal changes shake out, during which time the necessary analysis can be conducted to determine the impact.

Well-advised state lawmakers may also spend time considering to what degree it is constitutionally permissible for a state to adopt any expense disallowance provisions based on non-US activities, but it’s probably too early to speculate, and I would not expect this to take up much airtime in the debates.

I am reminded of the public comments of California tax reform activists to the Bush tax cuts in the early 2000s,1 to the effect that since the federal government was no longer collecting a “fair share” from the people, the state would be harmed, and California should increase taxes to make up for the shortfall. As possible current evidence that states could diverge from federal action, Gov. Jerry Brown (D) pointed out in his January State of the State address that with the funding of “tens of billions of federal dollars,” California “embraced the Affordable Care Act” with resulting coverage for “over five million people.”2 He then vowed and encouraged other governors, and presumably lawmakers, to “do everything we can to protect the health care of our people.”3

Already in California, we can see some tension brewing between a more territorial regime desired by Congress and the administration, and an assertion of worldwide combined reporting. S.B. 567 (Sen. Ricardo Lara (D)) was recently introduced, which, among other things, would discontinue the water’s edge election for tax years beginning on or after January 1, 2017, with existing electors unable to elect water’s edge for tax years beginning on or after January 1, 2023.

There has been some thought that repatriation (assuming an effective repatriation of cash were adopted) might lead states to up their game in terms of competing for business investment through enhanced statutory credits or incentive programs. Looking again to California, the evidence does not quite bear that out in terms of notable bills, at least not yet. S.B. 337 (Sens. Patricia Bates (R) and Janet Nguyen (R)) merely proposes special fund allocation for any influx of revenue related to repatriation. Notably S.B. 364 (Sen. John Moorlach (R)) contains skeletal language to “address comprehensive tax reform.”

While it may be somewhat early to speculate on what will be the state-by-state reaction to enacted federal tax reform, it is not too early for taxpayers to consider what may be necessitated by these changes. Some of that may involve consideration of accelerated deductions, though resources should also be directed to managing the multiple and potentially disparate necessary changes to systems and processes to deal with staggered conformity, partial conformity, and disconformity. In other words, the more things change, the more they stay the same.

1 John M. Broder, “Budget Deficit Climbs Steeply in California,” The New York Times, Dec. 19, 2001. Comments took place at the last California Tax Policy Conference funded by the Board of Equalization and Franchise Tax Board when California was facing a fiscal 2001–2002 budget deficit of $4 billion. By fiscal 2011–2012, that deficit was nearly $27 billion. (Historical budget data back to 2007.) California had been back “in the black” of late but the governor’s 2017–2018 proposed budget predicts a $2 billion deficit.

2 “Governor Brown Delivers 2017 State of the State Address,” Jan. 24, 2017. “$1.9 Billion Error Adds to California Deficit Projection,” The Mercury News, Jan. 18, 2017. The aforementioned projected budget deficit is reported as being related to underestimated Medi-Cal costs.

3 Id. It is worth noting, however, that California lawmakers remain constrained by the requirement of a two-thirds vote of each house in order to enact a bill that increases tax for even one taxpayer. Such an environment potentially makes any California reaction to tax reform difficult, notably one that may result in an expected tax increase.

Already in California, we can see some tension brewing between a more territorial regime desired by Congress and the administration, and an assertion of worldwide combined reporting.

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