The tax plan President Donald Trump unveiled earlier this month was a one-page outline that left much to be desired in terms of detail. The Administration says more will be revealed in the coming weeks, leaving stakeholders unclear on the future of tax reform.
Still, there are some important things worth noting about what Trump’s initial plan could mean for state governments. First, let’s look at a few of the biggest items. For the full list, see this write up from the Tax Foundation.
- Consolidates the current seven tax brackets into three, and applies income tax rates to 10 percent, 25 percent, and 35 percent.
- Doubles the standard deduction to $12,700 for single filers, and $25,400 for married filers.
- Eliminates all itemized deductions except for charitable contributions and mortgage interest.
- Eliminates the 3.8 percent Net Investment Income Tax.
- Reduces the corporate tax rate to 15 percent (from 35 percent) and creates a maximum tax rate of 15 percent on pass-through business income.
- Exempt foreign-source income from U.S. tax.
- Applies a one-time repatriation tax on companies bringing their foreign profits into the U.S.
What’s next: Any changes to the definitions for personal and for business income and changes to what can be deducted from that will impact states and localities. That’s because most state tax codes are connected to the federal tax system in one way or the other. According to research by the Pew Charitable Trusts, 37 states and the District of Columbia use the federal government’s definitions for income and for deductions. In about half the states, taxpayers calculate their earned income tax credits based on the federal rate.
The Tax Foundation took a look at what would happen to state revenues in the event of Republican-sponsored tax reform. The foundation’s scenario includes many items in Trump’s tax plan, as well as aspects of House Speaker Paul Ryan’s plan. The conclusion was that reform would result in a revenue boon for most state governments. That’s largely because taxable state income would increase thanks to the elimination of so many itemized deductions. States would suddenly have a much larger tax base without correspondingly lower rates, leading to higher state-level revenue.
The bottom line: On balance, having too much money is a good problem for states to have and it’s certainly a positive for credit ratings. It will be up to each state whether to pocket the new revenue from their taxpayers or lower their rates. History suggests that most places will lower tax rates. When Congress passed the Tax Reform Act of 1986, states enacted a myriad of policy responses. Ohio was the first to act, cutting its state-level tax rates to return its new revenue back to taxpayers. Other states responded by adding back in standard deductions and personal exemptions to return revenue. Nine states, some of which had budget problems, decided to keep the revenue.
Observers expect a similar scenario if tax reform moves ahead now. Most states can probably be counted on to adjust their own tax codes and rates to return money back to their residents. But chronically struggling states -- like Connecticut, Illinois and Kansas -- might seize the opportunity as a revenue windfall. New Jersey, which has also struggled with shortfalls, doesn’t link to the federal tax code and would be largely unaffected.
For individual investors in municipal bonds issued by states and localities, all else being equal, a lower income tax would lower the need to buy tax-exempt securities. The same goes for a lower corporate tax regime. As such, we could potentially see less demand for tax-exempt municipal bonds as the tax burden lowers for individuals and corporations that traditionally purchase municipal securities for their tax-exemption.
Banner photo by Matt H. Wade CC BY-SA 3.0, via Wikimedia Commons