Paul L. Caron

Friday, March 25, 2022

Weekly SSRN Tax Article Review And Roundup: Eyal-Cohen Reviews Thimmesch's Tax, Incorporated: Dynamic Incorporation And The Modern Fiscal State

This week, Mirit Eyal-Cohen (Alabama; Google Scholar) reviews Adam B. Thimmesch (Nebraska; Google Scholar), Tax, Incorporated: Dynamic Incorporation and the Modern Fiscal State, 53 Ariz. St. L. J. __ (2021):

Mirit-Cohen (2018)

States’ fiscal stability is crucial to providing residents with health, economic security, and physical safety. Most states rely heavily on the personal income tax, which is often an unpredictable source of revenue. Yet, even more so, states increase the volatility of that stream of tax revenues by relegating tax-writing authority to Congress through referral or fully incorporating the federal tax code (the “Tax Code”) into their own laws.  

In this Article, Thimmesch reviews the practice of incorporation—also known as conformity, piggybacking, or delegating up, thereby excusing states from having to devise tax policy or craft income tax de novo. Perhaps the most notable examples to this phenomenon include the referral to federal level AGI, determination of a taxable gift, calculating tax basis, or allowing deductibility of business meal expenses, among others. 

How prevalent among states this phenomenon is? For purpose of state personal income taxes, twenty-one states generally engage in “dynamic incorporation” and automatically conform to changes made by Congress to the Tax Code. On the other hand, seventeen states incorporate the Tax Code on a “static” basis as it exists on a set date.

There are many benefits to incorporation such as administrative convenience, strengthening tax bases, and lowering enforcement costs. As Ruth Mason noted here, incorporation can save much legislative hassle especially as state legislatures meet less frequently, are limited in their term, and are often underpaid for their service. The federal government also benefits from state incorporation via the amplification of its policy choices by states alike. For example, states that offer tax benefits similar to those given by the federal government provide taxpayers with even greater incentives to engage in the favorable behavior.

But incorporation can also be costly and lower the state’s legislative experimentation. As Kirk Stark noted here aside from revenue loss and opportunity costs, incorporation also increases state volatility by pushing states to use that tax system more than they might do otherwise. The retroactive nature of federal tax changes makes state tax conformity especially challenging as it also relates to and affects other areas of the law such as banking law, environmental law, etc..

The effects of state incorporation practices were much notable to states budgets during the recent pandemic. With the enactment of the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) that provided large assistance package to taxpayers, that type of stimulus did not have the same effect for states with distinct financial constraints. As a result, states with dynamic incorporation provided similar tax cuts and payments of tax refunds by default and before state legislatures had the change to determine tax policy at the state level or the effect of such actions. For example, Colorado’s conformity with the CARES Act’s tax cuts cost the state nearly $100 million over fiscal years 2021 and 2022. Montana estimated revenue losses was just under $150 million and Michigan estimated losses were over $400 million.

States have the ability to safeguard against revenue and policy volatility by decoupling from federal changes with which they disagree or cannot afford. Yet, it is also costly for states to decouple from federal tax laws as they have to identify problematic provisions, work through their decoupling language, and negotiate their passage. Decoupling also increases tax preparation costs for taxpayers. And as I have noted here, legislation, especially in the area of taxation, can get entrenched and involve much inertia.

Thimmesch does a great job reviewing the budgetary, distributional, and political impacts of the costs of legislative incorporation and decoupling in the context of several recent bills that contained major changes to the Tax Code. He provides a thorough qualitative assessment of the costs of incorporation for the states over recent years by analyzing data from a 50- state survey on the impact of incorporation across six different tax changes including the Tax Cuts and Jobs Act of 2017 (“TCJA”), the CARES Act, and the Consolidated Appropriations Act of 2021 (“CAA”). These issues include, but are not limited to, elimination of the personal exemption, increase of the standard deduction, expansion of the bonus depreciation, restriction of business interest deduction, modification of net operating loss rules, limitation of excess business losses, PPP loan forgiveness, and retroactive application.

The results of this survey are remarkable – the form of state incorporation (static or dynamic) is highly correlated with ultimate state response to federal tax changes (decouple or incorporate). Nevertheless, dynamic incorporation created disconnect, not parity, between state and federal tax policy. These findings provide reason to seek a more independent and intentional state tax practice going forward, termed by Thimmesch “modernizing” incorporation procedures. He claims that the different functions of the federal and state governments, as well as their distinct political climate, results in federal tax legislation failing to reflect good state tax policy, undermining principles of democratic self-rule at the state level, and possibly hurting the most vulnerable of state residents.

As opposed to Michael Dorf’s account here regarding dynamic incorporation of foreign law being a simple task, Thimmesch asserts the transaction costs that make tax legislation impede optimal deviations in the case of state incorporation of federal tax laws.  As a remedy for the phenomenon, Thimmesch incorporates a normative proposal for states to diverge from provisions that do not fit their state tax policy. He acknowledges it is inefficient for states to evaluate every single federal tax change. In order to protect state interests but avoid losing the administrative benefits of incorporation (saving legislative time and costs of crafting, negotiating, and enacting), he reviews ways to make better appropriation choices and incorporation practices.

As an alternative, some possible design choices he mentions include adopting the Maryland model of “lagged conformity” (federal tax changes do not affect state law in the taxable year in which they are enacted) or automatically decouple from changes that exceed a certain revenue impact. States can also follow the New York model (an otherwise dynamic incorporation state) that during the pandemic protected that its tax base by affirmatively adopting static conformity for a limited duration. Lastly, borrowing from the Colorado model, states can clarify that during certain periods of time, dynamic conformity provisions will apply only to prospective changes.

In addition, Thimmesch proposes practices to be implemented along with the utilization of static incorporation but could also be helpful approaches for states that continue to use the dynamic approach. First, it is crucial for states to understand the cost of conformity by creating good and meaningful revenue loss estimates (perhaps even statutorily require them like Maryland, California, and Nebraska legislators) in the same manner as the tax expenditure part of the U.S. budget. Second, states can utilize coordination institutions and mechanisms such as National Conference of State Legislatures, the Federation of Tax Administrators, and the Multistate Tax Commission, not only to achieve cooperation and uniformity in multistate transactions but also to create model legislation and ease federal-state conformity. Third, states should recognize the harm certain federal tax changes impose on state budgets and create a presumption against adoption problematic provisions such retroactive legislation, tax deferrals, and subsidizing investment incentives. Forth, states ought to conform and decouple better by considering how to do so in a manner that will endure future federal tax changes and reduce compliance challenges to the taxpayers. For example, setting up conformity dates to review the need for legislative change can help in overcoming some inertia against decoupling (although as I pointed out sunset provisions and deadlines can possible achieve the opposite goal and embed legislative inertia). Lastly, states must communicate better when their legislatures have decoupled.  

Thimmesch concludes that states’ debt is a reasonable way to manage short-term downturns while remaining conservative with borrowing given states’ smaller economies and inability to print money. As states are looking to balance post-pandemic fiscal policy, Thimmesch asserts that additional borrowing capacity makes more sense than requiring budget cuts that impact vulnerable populations during troubled times. Incorporation related directly to state authority and subversion of democratic principles and taking a dynamic approach subjects states to fiscal volatility. Thimmesch’s Article is appropriate and timely. After the dust settles on the recent pandemic, it will be helpful for state policymakers to rethink this process and evaluate possible legislative changes before they take effect.

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

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