As Congress presses forward with reforming our federal tax code, an often overlooked aspect is the vast majority of state tax codes that are directly linked to the federal tax code. This means that if federal tax reform is successful, many states will find their own tax code out of date, and some states will embark on their own tax reform process.
Although no state conforms to the federal code in all respects, to provide a streamlined tax filing process, most states have coupled their tax code to federal definitions. For example, 27 states use the federal definition of adjusted gross income, and 41 states rely on the federal definition for corporate income.
Twenty states plus the District of Columbia automatically adopt changes to the federal tax code as they occur. For these states, it means that federal tax reform will directly and immediately affect their income tax codes.
Another 21 states conform with the tax code as it exists at a specific “fixed” date, meaning future federal tax changes will not affect the state code unless the state legislature takes affirmative action. Fixed-date states do tend to update their conformity with some regularity, but may not have the immediate pressure to update their tax code following a federal re-write.
These states and the District of Columbia automatically update their tax codes to conform with the federal code: Alabama, Alaska, Colorado, Connecticut, Delaware, Illinois, Kansas, Louisiana, Maryland, Massachusetts, Missouri, Montana, Nebraska, New Mexico, New York, North Dakota, Oklahoma, Rhode Island, Tennessee, and Utah.
States that use a fixed-date conformity, requiring deliberate legislative action to adopt any changes made to the federal code, include: Arizona, Florida, Georgia, Hawaii, Idaho, Indiana, Iowa, Kentucky, Maine, Michigan, Minnesota, New Hampshire, North Carolina, Ohio, South Carolina, Texas, Vermont, West Virginia, and Wisconsin.
States that adopt only some components of the current federal tax code, or materially modify those provisions, include Arkansas, California, Mississippi, New Jersey, and Pennsylvania.
Nevada, Washington, Wyoming and South Dakota do not impose corporate income taxes (there is an exception for South Dakota financial services companies). Meanwhile, Alaska, Florida, Nevada, New Hampshire, South Dakota, Texas, Washington, and Wyoming do not levy an individual income tax. These states will not need to reform their codes.
However, if the majority of states are forced to examine their tax codes, even non-income tax states could face political pressure to review their tax systems. In addition, federal tax changes, such as disallowing the federal deduction for state sales taxes, may also pressure sales-tax dependent states to examine their tax regimes.
The experience of the Tax Reform Act of 1986, which is the last comprehensive overhaul of the federal tax code, suggests that states will respond in different ways. Some states may experience an increase in tax revenue, particularly those states that remain coupled to the federal rules for itemization.
Following the 1986 Act, in response to the revenue increases, 18 states reduced nominal tax rates, and 22 states increased the personal exemption or personal credit. Meanwhile, 23 states increased the standard deduction. In the four years immediately following the 1986 Act, nine states restructured their entire income tax regime.
On the whole, states tended to mirror the federal reforms by broadening their tax bases, lowering rates, simplifying their codes, and increasing progressivity.
The lesson from the Tax Reform Act of 1986 is that states will respond to federal tax reform. Those changes may be tweaks or major overhauls. If Congress is successful in reforming the tax code in 2017 or 2018, we must be prepared for tax reform to move to state capitals across the country. That may bring new challenges, but also opportunities.