There is a lot of speculation that Congress will pass, and the President will sign, a comprehensive tax reform bill later this year. If passed, it could be the most sweeping overhaul of the tax code since the Tax Reform Act of 1986. Surprisingly, it is getting very little attention from state policymakers even through it could have dramatic implications for the states because of the interaction between state income tax laws and the federal Internal Revenue Code (IRC).
Tax reform may actually happen for three reasons. First, tax reform has been a priority of Speaker Paul Ryan and the House Republicans for several years, and they have a fully formulated tax reform plan that is “ready to go.” This contrasts with the vague plan proposed by the President, which is not fully baked. However, there are enough similarities between the Ryan House Republican plan and the President’s tax reform goals that the President could easily adopt the Ryan plan as his own.
The second reason is trade. The President has threatened tariffs on foreign imports, but imposing tariffs would likely provoke a trade war with our foreign allies that could hurt key domestic sectors like agriculture. However, tax policy changes that promote U.S. manufacturers and exporters could accomplish many of the President’s trade goals. The Ryan tax plan contains a corporate tax provision called a “border adjustment” that would operate like an import tariff – but potentially without running afoul of our trade agreements.
Essentially, the border adjustment would not allow businesses to deduct the cost of imports against their revenues when determining taxable income. For example, under current law, a company that pays $900 for a product imported from China that it sells for $1000 would have $100 in taxable income, assuming no other deductible expenses. Under the Ryan plan, that same company would not be able to deduct the cost of the item from its income, and its taxable income would jump dramatically to $1000. However, if that same company bought the $900 item from a US manufacturer, taxable income would be $100 just like under current law. While this is a dramatic oversimplification of the border adjustment, it is easy to see why this feature of the Republican tax plan fits with the President’s agenda to boost domestic manufacturing.
On the personal income tax side, the Ryan plan would dramatically reduce the number of itemized deductions, preserving only two: home mortgage interest and charitable contributions. It would also expand the standard deduction and introduce new credits for families.
Both the personal and corporate income tax provisions would result in a significant increase in the amount of income subject to taxation. To prevent this base expansion from resulting in a tax increase, the proposal would significantly lower tax rates for corporations and individuals. The top rate for individuals would drop from 39.6% to 33% for taxable income above about $200,000. For “C” corporations, the top rate would drop to 20% from the current 35%.
For the federal government, the combination of base expansions and rate reductions would have the net impact of reducing federal revenues by between $200 billion and $2.4 trillion over 10 years. This widely divergent estimate depends upon whether the analysis aggressively uses “dynamic scoring” to offset tax cuts with the new revenue that would result from higher economic growth. That is a debate for another day. The intent here is to consider the impact of these potential federal tax changes on Vermont revenues.
There are two points where most of the 42 states with income taxes integrate their tax laws with the Federal Code. Most states start with federal gross income or adjusted gross income, while Vermont and five other states start with federal taxable income. Essentially, Vermont and those five other states allow the federal rules for the standard deduction, itemized deductions, and personal exemptions to apply while the other states that couple to the IRC using adjusted gross income have their own rules for these deductions.
The tax changes discussed above will have the effect of increasing adjusted gross income and federal taxable income. Therefore, the majority of states that couple with the federal IRC at those two starting points are likely to see a significant increase in state income taxes unless they pass legislation to reduce tax rates or make other changes to the tax base. This is very similar to what happened with the Tax Reform Act of 1986, when states had to decide whether to keep or give back the tax “windfall” to taxpayers.
The Tax Foundation, a non-partisan think tank based in Washington, is currently working on a project to come up with state-specific revenue estimates of the impact of the Ryan plan on state tax revenues. Since Vermont’s marginal tax rates are relatively high compared to other states, the potential tax windfall for Vermont could be very significant.
If federal tax reform is enacted, this will not be an issue for the Vermont Legislature until the 2018 session and will not have significant implications until the FY2019 budget. However, it does pose some interesting political questions for policymakers in Montpelier. Governor Scott has pledged not to raise taxes and fees, and he has the power of the veto (along with enough Republicans in the Vermont House to sustain his veto) to keep this pledge. However, federal tax reform could result in a revenue windfall that could only be prevented through legislative action. In other words, if the legislature did nothing, Vermonters’ taxes would go up. This gives the Governor less leverage – although he would have the bully pulpit in an election year.
At the beginning of this post, I said that there were three reasons why federal tax reform may happen this year. I previously only listed two. The third compelling reason for tax reform is that it could complement Republican efforts to shift programs back to the states.
The Trump administration has reiterated its desire to turn the Medicaid program over to the states under a block grant system. Tax reform that provides states with a potential revenue windfall would help Republicans in Washington justify devolving Medicaid and other programs back to the states. They would be giving states the ability to recapture some of the federal income tax cuts on individuals and corporations to pay for programs that are being cut by the federal government – if they choose to do so. Each state legislature and Governor would make those policy choices.
It would put states like Vermont – with average incomes and generous government programs – in a very challenging position. In the short term, it might be possible to offset federal tax reductions and program cuts with additional income taxes on Vermont residents and businesses that would allow the state to continue its generous programs. Over the long run, however, given the demographic, economic and revenue challenges facing Vermont, it would be very difficult to sustain our generous social safety without the federal government.
Scott Mackey is managing partner at Leonine Public Affairs.