Paul L. Caron

Friday, October 16, 2020

Weekly SSRN Tax Article Review And Roundup: Kleiman Reviews Strategic Nonconformity To The TCJA

This week, Ariel Jurow Kleiman (San Diego) reviews a two-part essay, Strategic Nonconformity to the TCJA, Part I: Personal Income Taxes, 97 Tax Notes State 17 (July 6, 2020), by Adam Thimmesch (Nebraska), Darien Shanske (Davis), and David Gamage (Indiana); and Strategic Nonconformity, State Corporate Income Taxes, And the TCJA: Part II, 97 Tax Notes State 123 (July 13, 2020), by Darien Shanske, Adam Thimmesch, and David Gamage.

StevensonNo one reading this review will be surprised to hear that states need cash. They need it to fund vital public services and to shore up coffers eviscerated by the economic fallout of the pandemic. While borrowing and federal support are both logical revenue sources, state borrowing limits prevent deficit spending and aid to state and local governments has been a major sticking point in federal stimulus talks. For the foreseeable future, states may be on their own.

Well, not entirely on their own. They do have some very able tax law scholars to help them navigate these rocky fiscal shoals. In this two-part essay, Adam Thimmesch, Darien Shanske, and David Gamage offer several ways that states can raise revenue during the current crisis. Part of a larger effort called Project SAFE (State Action in Fiscal Emergencies), this two-part installment considers how states’ tax laws should or should not conform with changes enacted in the Tax Cuts and Jobs Act (TCJA).

As a quick background, most states’ tax laws conform with the federal Internal Revenue Code to some degree. Some do so automatically, others regularly by an act of the legislature, and others only selectively. Upon enactment of the TCJA most states followed their default conformity practices and adopted certain TCJA changes either automatically or pro forma. Certain of the TCJA provisions offered benefits to taxpayers and thus reduced state revenue; others limited deductions or otherwise raised revenue.

While acknowledging that raising taxes in the current climate is fraught, the authors make several strong arguments for why states should do so. Perhaps most importantly, they remind us that raising taxes does not happen in a vacuum. Rather, tax increases prevent harmful service cuts. They also argue that joint sacrifice is necessary during times of crisis, especially among those who have suffered relatively less, and especially among those receiving recently enacted federal tax benefits. Further, federal support is necessary but lacking, leaving self-help as the only reasonable alternative for states. Moreover, they reason, to the extent the federal government cannot support states because of tax benefits provided through the TCJA during boom years, states should now feel justified clawing back those benefits during lean times.

The TCJA’s most significant personal income tax changes included reforms to the rate schedule, personal exemptions, and the standard deduction. Rather than temporarily modifying standard deductions or exemptions, the authors argue that states should increase the progressivity of their tax rate schedules. Doing so might mean abandoning flat income taxes, adding income brackets at the top, or raising rates on existing top brackets. I consider this suggestion further below.

The authors also address two business tax benefits. Part I considers the 20% deduction for Qualified Business Income (QBI), one of the TCJA’s more vexatious provisions. More than merely decoupling from the QBI deduction, they argue that states should impose an additional surtax on the QBI of high-income earners. (Shankse developed the proposal further in this prior piece.) Such a tax would capture the QBI windfall that taxpayers receive at the federal level.

Part II considers the TCJA’s provision for full expensing of business assets, arguing that states should decouple their systems from the provision. Doing so seems eminently sensible. Indeed, retaining full expensing at the state level essentially allows federal policymakers to enact generous business tax incentives within individual states. There seems scant policy justification for such federal meddling in state fiscal systems, particularly during an economic crisis.

The essays are titled “Strategic Nonconformity,” and their substance bears out the “strategic” part by also noting several ways that state conformity with TCJA changes would raise additional revenue. Specifically, the authors argue that states should adopt interest limitations from § 163(j) (but not subsequent loosening in the CARES Act) and conform state tax systems to the GILTI tax, the BEAT, and § 965 transition tax. Adopting these provisions would allow states to target tax base erosion and profit shifting, which plague state systems similar to the federal system.

Regarding the authors’ suggestion to increase income tax progressivity, it is worth noting that certain flat income tax structures are enshrined in state constitutions. For instance, the constitutions of Illinois, Massachusetts, and Michigan all preclude progressive income taxes. Other states, like Alabama, house income tax rate caps in the constitution. In such states, increasing income tax progressivity will require a constitutional amendment, which would in turn require voter approval (in all states except Delaware). Notably, Illinois’ provision is up for repeal in the upcoming election, but no other state is floating such a constitutional amendment. Thus, in most states with constitutional income tax restrictions, increasing income tax progressivity will need to wait another electoral cycle.

Fiscal austerity often feels like a foregone conclusion in times of crisis, but it need not be—particularly when recent tax cuts leave revenue on the table. States can and should roll back such tax cuts in times of fiscal crisis. These two essays, along with other Project SAFE papers, provide an invaluable policy menu for states contemplating how to do so.

Here’s the rest of this week’s SSRN Tax Roundup:

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