When it comes to taxes, federal tax reformers shouldn't forget the states

While most presidential candidates are proposing big, bold changes to the federal tax code, they seem to be paying little attention to what those revisions would mean for state and local governments. And those implications could be substantial.

While most presidential candidates are proposing big, bold changes to the federal tax code, they seem to be paying little attention to what those revisions would mean for state and local governments. And those implications could be substantial. That, at least, was the consensus at today’s panel discussion sponsored by  the Urban Institute’s State and Local Finance Initiative and the Tax Policy Center.

These ambitious tax proposals come in three basic forms: Donald Trump’s plan to sharply cut tax rates while eliminating nearly all tax preferences; Ted Cruz’s proposal to replace many federal taxes with a flat rate individual income tax and a Value-Added Tax; and Bernie Sanders’s many tax hikes, including rate increases on existing income and payroll taxes, a carbon tax, and a financial transactions tax. Hillary Clinton’s more modest tax ideas would have less impact on states.

These proposals would affect states in dramatically different ways. For instance, because states often piggy-back their own income taxes on the federal system, they could receive a revenue windfall if Congress eliminates most tax deductions.  Governors could enjoy a political win/win: A revenue bonanza generated by federal tax changes combined with an opportunity to soften the blow by cutting state taxes.  The problem, of course, is that the screams of those who’d lose out would overwhelm the gratitude of the winners.

But lower-the-rates, broaden-the-based tax reforms-- such as those of Trump and Cruz--also come with downsides for states. 

For example, sharply lower federal tax rates make tax-exempt bonds much less attractive. Eliminating taxes on most other investment income, as Cruz proposes, would make the market for municipal debt even less attractive. The resulting higher borrowing costs for state and local governments is the Number #1 concern for most state chief executives, National Governors Association executive director Scott Pattison said: “It is all about munis.”

Eliminating tax preferences would also wipe out the federal deduction for state and local taxes, a step that could increase voter pressure on states to lower their taxes. TPC’s Frank Sammartino and Kim Rueben have a new paper on the state and local deduction here.

Ted Cruz’s proposed value-added tax would come with its own set of trade-offs. Because he’d eliminate all corporate taxes, states would be faced with the choice of losing those revenues or having to decouple their corporate tax from the federal system. States could replace their sales taxes by piggybacking on the federal VAT, eliminating a level of state tax administration. But would a VAT fully replace sales and corporate tax revenues?

Because the GOP tax plans would also add trillions of dollars to the federal budget deficit, they’d increase pressure on Congress to sharply cut spending. And because a large chunk of federal money goes to the states (through programs such as Medicaid, education, transportation, housing, and public safety), those grants would come under severe pressure, warned Liz McNichol, a senior fellow at the Center on Budget and Policy Priorities.

The Sanders tax agenda would create an entirely different set of problems. His carbon tax would hit states that produce fossil fuels especially hard. And his steep increases in federal taxes could increase pressure on states to lower their taxes.

All these interactions are enormously complicated, said Jeff Friedman, a partner at the law firm of Sutherland Asbill & Brennan. But, as he and other panelists noted, federal tax reformers often pay little attention to what those changes mean for states.

Maybe it will be different next time. But probably not. 

This article first appeared in TaxVox.