WASHINGTON – Efforts in California and New York to minimize the impact of the new $10,000 federal cap on the deductibility of state and local taxes is the beginning of a much bigger struggle for all states to adjust to the recently enacted federal tax law changes.
The two states are considering ways to turn state and local taxes into charitable deductions that would be federally deductible or converting state income taxes into payroll taxes that would have the effect of a deduction.
“They have had foisted upon them a whole complex set of issues and decisions that don’t come around very often,” John Hicks, executive director of the National Association of State Budget Officers, told The Bond Buyer.
Unlike the last round of federal tax reform in 1986 which was signed into law over the summer and gave states more than six months to work out adjustments, the new legislation was signed into law Dec. 22.
“Many legislative sessions are starting this week,” Hicks said. “That’s an unusual circumstance for states.”
Missouri could face a $58 million revenue loss because of federal tax reform, University of Missouri economist Joseph Haslag said in December. Haslag, who assists that state in forecasting tax receipts, looked at a variety of tax law changes including doubling the standard deduction and eliminating the personal exemptions for individual taxpayers.
But there will be other major factors in play, including a reduction in the federal corporate tax rate to 21% from 35%, Hicks said. In some states the lower rate will decrease tax revenues and in others it will increase them, he said.
Montana is projecting lower state tax revenues as a result of federal tax reform but Colorado and Idaho are forecasting increases, Hicks said, emphasizing the impact on each state will vary.
Many of the 41 states with their own income taxes also will have to decide whether to enact laws conforming to the new federal code.
“Do states conform with the personal exemption, which is being eliminated?” Hicks asked. “Do they sit still and let that happen? Or do they create their own exemption, which many states do anyway?”
Federal adjusted gross income is used as a starting point by 33 states and the District of Columbia to determine taxable income, according to the National Conference of State Legislatures. Six others use federal taxable income and five use their own formulas.
Many local officials in high tax states such as New York, California, New Jersey and Connecticut are concerned that the new cap on state and local taxes, also known as SALT, will reduce home values. That, in turn, would reduce property tax revenues unless they increase their tax rates.
New York Gov. Andrew Cuomo has raised the possibility of hiking state payroll taxes – which are federally deductible for businesses – to offset a possible reduction in state income taxes.
One California lawmaker last week introduced legislation to offset the new cap on SALT by allowing Californians to claim their state taxes as a federally deductible charitable contribution.
The Protect California Taxpayers Act (SB 2267) proposed by California Senate President pro Tempore Kevin de León, D-Los Angeles, would establish a 100% state tax deduction for donations to the California Excellence Fund, which, in turn would help fund state government.
De Leon already is the author of another tax credit. Californians can claim a 50% tax credit for donations to the College Access Tax Credit Fund.
Thirty three states, including California, have 113 different tax credits that can be deducted from federal taxes, according to a recent report by eight law professors from six law schools that include Stanford University, UCLA and the University of Chicago.
Although most of the state tax credits cover only a fraction of the donations – for instance, 25% or 50% -- and many are targeted at businesses, a few credit the full amount to individuals.
South Carolina allows a 100% tax credit for donations of up to $2 million to the Industry Partnership Fund at the South Carolina Research Authority, but there’s a $6 million statewide limit on those donations.
Alabama also allows a 100% credit for up to 50% of a taxpayer’s tax liability of up to $50,000 for donations made to scholarship granting organizations. Another similar 100% tax credit applies to donations made to local economic development organizations through the end of fiscal 2020.
Montana has two 100% tax credits for educational donations, but they are each capped at $150 per taxpayer.
Likewise, Oregon has a limit of $500 for individuals and $1,000 for joint filers who receive a 100% credit for donations to the Trust for Cultural Development.
David Gamage, a professor at the Indiana University Maurer School of Law who was a co-author of the report by eight law professors, said the legality of federally-deductible tax credits offered by states is well established. The IRS and federal courts have issued rulings in support of them.
“Legislatures can shift from nondeductible ways of raising money to deductible ways of raising money,” Gamage told The Bond Buyer. “So you are seeing some states explore aggressive versions of doing this like the legislation in California.”
Gamage thinks the California bill “is written stupidly" at the moment.
”Rather than offering a 100% tax credit for taxpayer donations to the state’s general fund, a state law allowing a 90% credit to a more specific fund would have a better chance of withstanding a legal challenge, he said. “A 90% deduction would have basically the same effect,” Gamage said. “There is nothing to prevent California from giving a dozen options or ‘X’ number of options to the big state program areas, higher education, Medicaid, etc. or a rainy day fund.”
Some state tax credits already are being used to undermine public education and the new federal cap on state and local tax deductions could exacerbate that problem, according to Matt Gardner, a senior fellow at the Institute on Taxation and Economic Policy.
Gardner pointed to South Carolina’s 100% tax credit for scholarships to private schools as an example. “The pretty clear implication is that allegedly charitable donations can be a profit center for Americans who are rich enough to make them,” he said.
Gardner’s colleague at ITEP, Carl Davis, released a paper in December describing the South Carolina tax credit for donations to private school voucher funds as a loophole that benefits the wealthiest families in the state.
The 100% tax credit is available for private school voucher donations in eight states -- Alabama, Arizona, Florida, Georgia, Montana, Nevada, Pennsylvania, and South Carolina --- the ITEP paper said.
Private schools in five states – Alabama, Kansas, Montana, Oklahoma and Virginia – can expect a $50 million windfall in 2018 as result of the new federal tax legislation, the ITEP paper said.
“You would hope this is a ludicrous enough of a result that any lawmaker would find it hard to defend on its face,” Gardner said.
Efforts to undo the $10,000 cap on state and local deductions have already begun in Congress. Two New York lawmakers, Reps. Peter King, a Republican, and Nita Lowey, a Democrat, on Jan. 8 introduced legislation (H.R. 4740) to eliminate the new $10,000 cap on state and local taxes that can deducted.
House Ways and Means Committee Chairman Kevin Brady, R-Texas, already has told reporters it won’t be considered.
But the SALT deduction is expected to be a campaign issue raised by Democrats in some key House races in November as part of their effort to retake control of both chambers of Congress.
Democratic Congressional Campaign Committee spokesman Tyler Law said some Democratic House candidates already are campaigning on the issue. “Increasing middle-class taxes will continue to be a serious problem for House Republicans in the midterms,” he said.