Tax reform goes local. What's the effect?

The need for fundamental federal tax reform is critical.  Often overlooked, however, is the fact that any such reforms will also affect the tax and fiscal policies of state and local governments.

In testimony before the Senate Committee on Finance this morning, I discussed what federal tax reform would mean for state and local governments and how Congress could help by coordinating tax law across states. Here are my opening remarks. You can find my full testimony here.

With increasing concerns about the federal deficit, fairness, and the complexity and inefficiency of our tax system, the need for fundamental federal tax reform is critical.  Often overlooked, however, is the fact that any such reforms will also affect the tax and fiscal policies of state and local governments.  Although the country’s economic condition is improving, state and local governments are still struggling to balance their budgets.  They also play an important role in our economy, running about half of all domestic public programs and with state and local spending making up about 15% of gdp.

 Decisions about changing federal policy should take into account the potential effects on state and local government budgets in both the short and the long run.

 I will make 4 points today.

 Federal tax policy and reform can help or hurt states. Federal policy affects how attractive specific taxes are for state and local governments and, therefore, how those governments organize their tax and revenue systems.  State revenue sources—especially income taxes—often piggyback on federal rules. More specifically, statutory changes in federal law can result in significant increases or decreases in state revenue. For example, state income tax revenue increased after the 1986 tax reform expanded the federal income tax base, and allowed states to also reduce their rates. In contrast, the elimination of the state and local tax deduction could increase the cost to state and local governments of providing services.

 Unstable federal tax policy trickles down to the states and uncertainty is especially problematic for state and local governments.  State and local governments are required to pass balanced budgets every year.  This requires being able to accurately forecast revenues. Problems with state tax systems are exacerbated by uncertainty in federal tax rules. Temporary extensions of credits, deductions, and tax rates complicate state forecasting. Policy changes and uncertainty can directly affect state tax bases through changing definitions of income or indirectly due to changes in taxpayer behavior.  Especially problematic has been uncertainty about future federal estate taxes and tax rates on dividends and capital gains, sources of volatile income for states.

 If fundamental tax reform is undertaken, transition relief might be important for state and local governments. Tax changes can help or hurt states, but understanding the short-run effects will be important and may require slower adoption of policies or some fiscal relief.  Understanding the state of the economy and the fiscal health of state and local governments will be important.

 Due to our federalist system, Congress has a role in helping to coordinate or protect the existing state and local tax base. State and local governments’ ability to raise revenue can be hobbled by limitations that Congress could remove. Most notably, Congress could enact legislation that could help coordinate action across states and would help enable state and local governments to collect taxes on internet and mail-order sales.

Other panelists explored the costs of current federal tax preferences—the state and local tax deduction and tax-exempt municipal debt—that affect state and local governments as well as how federal legislation could help state and local governments coordinate tax policy in the face of changing technology.  The hearing was lively and a good mix of both considering long-term reform and more practical measures that Congress is more likely to act on. 

Opening statements from Senators Baucus and Hatch and the other witnesses are here.