Fix the State Windfall from Federal Tax Reform

by Stephen D. Haner

Governor Ralph Northam recently announced the nomination of about two hundred economically-challenged portions of Virginia to become federal Opportunity Zones, a special designation similar to an enterprise zone created by the recent overhaul of federal tax laws. That’s good. But the economic opportunities available to all Virginians from the Tax Cuts and Jobs Act of 2017 are still in limbo.

Like most states, Virginia bases its tax code on the federal tax code – a practice called conformity.  The rules on income, deductions and credits that determine your federal taxable income serve as the starting point for your state taxes. Until 2002, Virginia’s conformity to the IRS Code was automatic. Starting in 2003 Virginia became a fixed-date conformity state, leaving it to the General Assembly to review and cherry pick from new federal tax provisions. It has chosen to de-conform from only a handful. Until now.

The 2018 Virginia General Assembly, following the advice of the administration, voted to conform to none of the tax changes for 2018. Individual and business taxpayers looking at the May 1 deadline for their first quarter state tax payments are having to base them on the 2017 federal tax code.

The federal changes were made late in the calendar year and their impact is still poorly understood at both the federal and state level. A decision in February to fully conform at the state level could have made state revenue projections less reliable. But it is not too soon for the state’s leaders to declare that their policy going forward is to conform to as many of the federal changes as possible, and to resist the temptation to let federal changes automatically result in a state tax increase for Virginians.

Full or almost full conformity to the rules should be the goal, with the tax brackets or rates then adjusted to produce revenue neutrality. If there is to be a revenue windfall, let it come from actual economic growth.

Inaction will produce higher state tax bills for many individuals due to changes to the federal standard deduction. Secretary of Finance Aubrey Layne recently told a legislative committee that a consultant has estimated more than 600,000 Virginia taxpayers will switch from itemized deductions to the standard deduction at the federal level for 2018. That will require them to also take the standard deduction at the state level.

At the federal level new lower tax rates offset the impact of losing those deductions. But with state tax rates staying the same, every $1,000 in lost deductions produces $57.50 in higher state income taxes. Even taxpayers who continue with itemized deductions at the federal level may see them shrink because of new limits, producing a higher state tax bill for them as well. To prevent a windfall the General Assembly will need to either increase the state standard deduction or lower individual rates.

The confusion caused by delayed decisions on conforming on business tax provisions is even greater, because the 2017 federal bill really reshuffled that deck.

A Virginia Department of Taxation presentation to the Assembly in January and one from the Division of Legislative Services highlighted new rules on losses claimed by businesses, on interest deductions, and on the amortization of research expenses.  There is a major new deduction for income from pass-through entities. The federal law doubled the expensing deduction for buying equipment from $500,000 to $1 million, one of the provisions expected to quickly juice the economy. The new law eliminates the domestic production activities deduction as a trade-off for lower federal tax rates.

When Virginia has refused to conform since 2002 it has usually been on business provisions like these and it may be tempted to do so again – putting Virginia companies at a disadvantage. It may also be tempted to try to tax all the off-shore income that Virginia-based companies are going to bring home and add to their federal returns.

Compare today’s lack of decision and discussion with the situation in 1986, when Congress passed the last major reform of federal taxes. There was an immediate push in Virginia to prevent a state-level revenue windfall. The push came from then-minority Republican legislators, and despite their minority status the issue struck a cord and the General Assembly responded with several positive changes to state tax brackets and personal exemptions.

The 1986 changes were not as complex and were not as focused on business taxes. But that focus on the business side this time around makes Virginia’s response all the more important. It is time to start this debate.

As his lobbying activities wind down, my former Roanoke Times colleague Steve Haner may again become a regular contributor to Bacon’s Rebellion, with a focus on some of the state and local issues that were the center of his career for four decades in Richmond. He will remain in business as Black Walnut Strategies for the near future. 

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4 responses to “Fix the State Windfall from Federal Tax Reform

  1. This is a really important issue that most folks know almost nothing about but the bottom line seems to be that if Virginia “follows” the Feds – it will result in lower tax revenues – ergo budget impacts – shortfalls.

    The same thing happens to the Feds but they just put that on the deficit/debt. Virginia can’t do that.

    • “The same thing happens to the Feds but they just put that on the deficit/debt. Virginia can’t do that.”

      Virginia does do that by underfunding liabilities like its pension funds. At least the Feds are transparent about running deficits. Richmond hides them in underfunded pensions and then crows about balancing the budget.

  2. underfunded pensions ARE taken into account for credit ratings… though…

    I wonder if that also is what is endangering Virginia’s AAA rating?

  3. It is mainly the small reserve fund, but I suspect there is some interaction.

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