What the 'fiscal cliff' deal means for states

The fiscal cliff deal is done and the question on everyone’s mind: What about the states?  Okay, so only a handful of us are actually asking this question. But there are some important provisions that will matter to states still woozy from the Great Recession.

The good news for states is that American Tax Relief Act of 2012 will end much of the uncertainty that has plagued the income tax code in recent years. No longer will states have to guess what will happen to many provisions of the federal revenue code that were set to expire. The bad news is some states will lose revenue they were counting on from scheduled changes in the federal estate tax that won’t happen.

The federal credit for state estate and inheritance taxes is gone for good. The 25 dormant states that had an estate tax only when the federal credit existed will continue to not collect estate taxes.  (My brief on state estate taxes and the fiscal cliff has more details but ATRA is the nail in the coffin on the state death tax credit.)  Twenty states and the District of Columbia, because they either have an inheritance tax or an estate tax independent of the current federal law, will continue to collect the tax that can still  be deducted on the federal return.  Five states completely repealed the estate tax.  Those  states with zombie estate taxes still on their books, knowing the credit is not coming back, may choose one of these options. Or some may just wait to see if Congress changes its mind again.

By engaging in a bit of wishful thinking that the credit would be revived, a few states included revenues from a resurrected estate tax in their latest budget forecasts. Now, with the credit gone for good, those states will have to hope for additional revenue from other taxes to avoid having to revise their projections downward. California used a projected—and now gone—$45 million in new estate tax revenue to help balance its 2012-2013 budget.Wisconsin’s executive budget office included it in its November 2012 forecast. The Colorado Legislative Council Staff was more prescient, revising its revenue forecast in December, eliminating estate tax revenue that had been previously included. 

The deal also makes several changes to the individual income tax that will affect states.

The restoration of the top 39.6 percent rate on ordinary income and the new 23.8 percent rate (which includes the surtax for healthcare) on capital gains for high-income households won’t affect the tax structures in most states.

However, states may see a short-term, and entirely misleading, run-up in revenues from taxes on capital gains realized at the end of 2012.  This will be driven in large part by investors taking gains in November and December in anticipation of higher taxes on investment income in 2013. States have been fooled in the past by investors accelerating gains to avoid a tax increase. One can only hope they’ll recognize this timing change is likely to be offset by lower capital gains taxes in the first part of 2013.

A handful of states will lose some revenue from higher federal taxes. Six (Alabama, Iowa, Louisiana, Missouri, Montana and Oregon) allow taxpayers to deduct federal income taxes from state taxable income. Thus, to the degree taxpayers pay more to Uncle Sam, they’ll owe less to their states.

The reinstatement of the limitation on itemized deductions known as Pease will reduce deductions, raising taxable income in states that allow the option of federal itemized deductions.  The reinstatement of the personal exemption phaseout (PEP) will have a similar effect for the five states that use federal taxable income as a state tax starting point: Colorado, Minnesota, North Dakota, South Carolina, and Vermont.

The permanent alternative minimum tax patch will mean that nearly 30 million middle- and upper- income taxpayers who would have been hit by the AMT are now protected. As a result, they’ll continue to benefit from deducting state and local income taxes on their federal returns, which is effectively a state and local subsidy.

Other changes include the five-year continuation of the earned income credit provisions, which affects 23 states and the District of Columbia that link directly to the federal credit, and the extension of the federal deduction for state sales taxes through 2013, benefitting taxpayers who itemize and primarily reside in states with no income tax.

Now, at least with regard to taxes, all the states need to worry about is what happens if Congress actually undertakes tax reform—when everything is likely to change yet again.