Federal Tax Cuts Leave States in a Bind

Hundreds of New Yorkers gathered outside Cipriani at 42nd Street in Midtown Manhattan on December 2, 2017.
Erik McGregor | Pacific Press | LightRocket | Getty Images Hundreds of New Yorkers gathered outside Cipriani at 42nd Street in Midtown Manhattan on December 2, 2017.

The federal tax overhaul cut taxes for millions of American families and businesses. But the law also had an unintended effect: raising the state-tax bite in nearly every state that has an income tax. Now, governors and state legislators are contending with how to adjust their own tax codes to shield their residents from paying more or, in some cases, whether to apply any of the unexpected revenue windfall to other priorities instead. The Tax Cuts and Jobs Act, which President Trump signed into law in December, did not directly affect state budgets. It cut federal tax rates, but also made other changes that mean more income will be subject to taxation. Because most states use federal definitions of income and have not adjusted their own rates, the federal changes will have big consequences for both state budgets and taxpayers. 

“Residents of the majority of states would experience an unlegislated tax increase,” said Jared Walczak, an analyst with the Tax Foundation, a conservative think tank.

Apart from the nine states with no broad-based income tax, nearly every state will face a similar decision. Almost all of the states base their tax codes in some way on federal definitions of income, before applying their own adjustments and deductions and setting their own tax rates. The federal tax overhaul, which eliminated or capped several deductions and exemptions, effectively broadened what counts as income for some families. Previously, for example, a married couple with three children earning $70,000 might have been taxed on only about $36,000 of that income, according to the Tax Policy Center, a research group. The tax law, however, eliminated the so-called personal exemption and made other changes, which could increase this family’s taxable income to about $46,000. The changes leave families owing tax on a larger share of their income, without the reduced rates or new credits to soften the blow. A handful of states have already taken action, in some cases using the extra revenue from the federal law as lubrication for deal-making. Colorado, for example, took advantage of its estimated $200 million in extra revenue to pass a budget that included extra funding for roads, public education and school security. Idaho, on the other hand, moved quickly to return the revenue windfall to residents through tax cuts. In California, the legislature has not even tried to pass a conformity bill, choosing instead to focus on developing workarounds for the federal law’s cap on state and local tax deductions, which would hit California residents especially hard. Several factors are complicating the issue for states. Congress passed its tax overhaul late in the year and with minimal debate, giving states relatively little time to assess the effects and plan a response. Even now, the full impact on state budgets is not clear, meaning legislatures are deciding how to take advantage of a revenue stream that could fall short of estimates. In addition, most of the changes to the individual tax code expire after several years, further muddling states’ plans. Moreover, the tax debate is hitting as state budgets are strained by rising health care and pension costs, among other factors. Those strains could worsen in coming years if the federal government cuts back funding — perhaps because of deficits caused, in part, by the tax law itself.