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Module
4: Economics
and the State Budget
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Economic Impact
of Federal Tax Policy
States
can be affected by changes in federal tax law in three primary
ways: marginal tax rate changes, administrative rules changes,
and tax expenditure changes. In each case, federal changes can
be considered preemptive in the sense that federal tax policies,
rules, and programs seldom take into account the impact on state
policies, rules, and programs.
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Marginal
Rates, Administrative Conformity,
and Tax Expenditure Rules
When
federal marginal rates change, state tax revenues will be driven
up or down by economic activity encouraged or discouraged by
changing tax rates -- if the state makes no corresponding adjustment
to its rates. When federal tax administrative rules (like record
keeping, reporting, or timing) change, significant pressure
will be put on states to conform their rules to federal rules
to hold down administrative costs for individuals and companies.
For federal tax expenditure rules, the issue of conformity is
most pressing. If the state and federal governments have different
tax credits or subsidy arrangements (different in terms of structure,
not percentages or levels), states will usually find that companies
will conform to federal law and frustrate attempts by states
to conduct entirely independent incentive programs.
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Corporate Profits Tax
The
major federal tax on businesses is the corporate profits tax.
Overall, the federal government marginal profits tax rate is
35 percent for large corporations, while for states, marginal
rates are between zero and less than 10 percent. Clearly, changes
in federal business profits taxes will be much more important
to business decision makers than proportionate changes to state
taxes.
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Personal
Income Tax
Federal
marginal personal income tax rates peak at 39.6 percent, while
states range between zero and less than 10 percent. The extent
that state personal income taxes are deducted from household
incomes subject to federal tax further reduces the ability of
state tax policy to affect household behavior. Thus, if tax
policy affects economic behavior, it is federal tax policy for
households or businesses. If sufficiently large, differences
between state tax rates could affect the location of economic
activity.
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Capital
Gains Tax
Another
issue of major significance is the capital gains tax. Over the
last twenty years, the rate at which capital gains have been
exposed to taxes has been the most volatile federal tax rule.
In the early 1980s, the rate was halved and a substantial amount
of previously-accumulated capital gains was exposed to taxation.
This rush was later accelerated in the 1980s as discussions
progressed toward increasing the exposure rate of capital gains
to taxes and ended with implementation of the higher exposure
rate. State governments that did not conform their exposure
rates for capital gains to federal rates experienced significant
growth in state personal income tax revenues when federal tax
rates fell. This revenue growth for states accelerated towards
the end of the "window of opportunity" for households. In the
largest states, this "revenue windfall" approached $1 billion
per year. As the window closed, these states experienced revenue
shortfalls of similar magnitude. This episode of capital gains
taxation is one of the clearest examples of the impact of federal
tax law on individual and corporate behavior. The 1997 federal
balanced budget agreement calls for a further reduction in the
tax on capital gains -- an action that will be felt in state
coffers around the country.
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