State Tax Battles Loom as Federal Revision Nears

By Bill Montague — September 17, 1986 6 min read



As the two-year battle over federal-tax revision nears its climax in Congress, officials in all but a handful of states are examining the future of their own revenue systems-and finding themselves faced with a host of uncertainties.

With the House and Senate now seen as almost certain to approve a compromise tax plan, governors, legislators, and other policymakers face the politically delicate task of making major changes in their own tax codes.

Such decisions may have deep implications for programs, such as education, which rely on state governments for a large share of their funding. In several states, education groups are already positioning themselves for the coming debate.

In about 22 states, federal revision will create an unexpected “windfall” because of the way their tax laws are linked to the federal code. For a smaller number of states, reform will have the opposite effect, reducing revenues.

In 17 states, legislators must decide whether to update their tax laws to bring them into compliance with the new federal system.

And states that rely heavily on sales-tax revenue may need to reevaluate that dependence in light of the proposed elimination of the federal sales-tax deduction.

“I think over the next five or six years you are going to see some significant changes,” said Gov. Richard D. Lamm of Colorado, who monitored the federal-tax-revision battle on behalf of the National Governors’ Association.

Major Repercussions Seen

“It appears safe to say that federal tax reform will have major repercussions which will affect state finance for years to come,” said Stephen I Gold, a fiscal analyst for the National Conference of State Legislatures. “Clearly, this will be one of the top fiscal issues facing legislatures in 1987.”

Most of the attention, Mr. Gold noted, has focused on the windfall issued the political dilemma it creates for state officials in an election year.

According to a study by the Advisory Commission on Intergovernmental Relations, the size of that bonus will vary widely from state to state, depending on the precise nature of the link between state and federal tax law.

Benefiting the most would be states that use the federal definition of taxable income, or allow the same deductions. The new system would eliminate many of those deductions, reducing the amount of individual income that could be sheltered from taxation.

Although federal tax rates would drop sharply, state rates would not, allowing states to reap a portion of the tax cut that otherwise would be passed on to their citizens.

According to the N.C.S.L.'S Mr. Gold, the bill proposed by the Senate would have resulted in higher state revenues than the House bill, with the final compromise measure falling roughly in the middle.

Windfall Said Exaggerated

Press accounts, Mr. Gold said, have tended to overemphasize the importance of the windfall, leaving the impression that states will only gain from tax revision. ''It’s the easy one. it’s the immediate one, but it’s also ... blown out of proportion.”

Some reporters, he said. have missed the fact that most states derive only a small portion of their revenues from their personal income taxes-less than 30 percent on average. Seven states have no income tax at all.

Still, preliminary figures show that for about a dozen or so states, the added revenues will total in the hundreds of millions of dollars-at a time when many state programs are facing sharp budget cuts.

New York Republican leaders, for example, estimate that their state’s revenues could climb by as much as $2 billion a year once the new federal system is fully in place. Illinois could gain more than $100 million, Ohio, $200 million, and Virginia as much as $180 million, according to officials in those states.

Opinions about how this largess should be handled are being aired in a number of state capitols-as well as on the campaign trail.

In many states, observers noted, the windfall would provide much needed revenue, without requiring legislators to vote for a tax increase. And some spending advocates are arguing that the extra revenue is not really a windfall at all, and should not be treated as such.

Illinois State Senator Dawn Clark Netsch, for instance, contended the money will only compensate for a host of revenue-losing provisions adopted by the federal government and emulated by the states in recent years-such as the business tax breaks granted in the Reagan administration’s 1981 tax bill.

''In 1981 not a single state raised its personal rates to offset the negative windfall,” observed the N.C.S.L.'S Mr. Gold. “Why should they lower rates now when the process is reversed?”

Political Pressure Mounts

Political pressures, on the other hand, may make it hard to resist calls for state-tax revision, including lower rates.

A number of governors are facing tough re-election campaigns this year, and several have already declared publicly that they will fight to make sure the entire windfall is passed on to the taxpayers.

In several states, education groups are moving quickly to stake out a claim on the additional money. The Ohio School Boards Association has suggested earmarking a portion of .that state’s windfall for local school districts, to be allocated on the basis of per-capita income.

According to Warren Russell, the association’s assistant executive director, the plan would not only raise about $120 million for the schools, it would also allow the districts to grant some tax relief to local property owners.

But Ms. Netsch, who is chairman of’the Illinois Senate’s Revenue Committee, predicted education groups in many states could find themselves in tough competition with some business interests, who lost big at the federal level and would like to recoup some of those losses with state tax relief.

“The corporations are pretty sharp about playing the states off against each other,” she said. “There is a good possibility that they will get more than their fair share of any relief.”

Need To Update

A number of states, however, will have no relief to give unless their legislatures revise their tax laws. These states-California, South Carolina, and Michigan, for example- tie their tax codes to the version of federal law that was in effect as of a certain date.

Unless these states update that link, federal revision-and the windfall-will pass them by.

In California, the issue is attracting little interest. Under state law, spending growth is limited by a formula based on the increase in population, income, and inflation. With the state expected to hit that limit next year, any windfall would have to be passed back to taxpayers, said Cathy Davis, a spoke man for the California School Boards Association.

Despite the reluctance of legislators legislators to update their tax laws-a move that opponents could label as a tax increase-they may have no choice, according to Gerald Miller, an economist with the National Association of State Budget Officers.

Not updating, he said, would re- I quire taxpayers to calculate their taxes twice using entirely different systems-the main reason state and federal codes were linked in the first place. “You would make a lot of people very angry,” Mr. Miller said.

Caution Urged

Instead of rushing to spend their windfall money or give it back to the taxpayers, state officials would be wise to take a wait-and-see attitude, Mr. Miller and other fiscal experts warned.

For one thing, any revenue increase from federal revision would not be apparent until the changes are fully in place, which would not occur for several years.

More important, according to Mr. Gold, states should be extremely leery of the revenue estimates developed by the U.S. Treasury and Congressional tax writers.

Those forecasts, he said, do not take into account changes in spending and investment behavior brought on by tax revision.

“I’m afraid that even though this is supposed to be ‘revenue neutral,’ it’s not going to be as ‘revenue neutral’ as we think it is,” he said.

These economic changes could result in unexpected revenue shortfalls in future years, as could a major recession, Mr. Gold added.

Finally, according to Mr. Gold and others, states may find any new revenue more than offset by severe budget cuts as a result of the federal Gramm-Rudman-Hollings deficit reduction law.

A version of this article appeared in the September 17, 1986 edition of Education Week as State Tax Battles Loom as Federal Revision Nears