The Big Beautiful Bill's Impact on State Taxes, Explained

Congress may have passed the One Big Beautiful Bill Act (OBBBA), but state lawmakers now face big choices. Most states link their tax codes to the federal system, meaning OBBBA’s provisions—good and bad—are about to ripple across state budgets.  
 
In this episode, we explain why federal tax changes can automatically affect your state tax bill, the costly new personal deductions with limited benefits, and the pro-growth business provisions that remove barriers to investment and jobs. 

Transcript

Kyle Hulehan: 0:00

hello and welcome to the Deduction a Tax Foundation podcast. I'm your host, Kyle Houlahan, and we are back with another episode today. And we are joined by Jared Waza, vice President of State Projects here at Tax Foundation. So. Jared, you may have heard that this one small piece of legislation passed the one big beautiful bill. I, I don't know if you know anything about it or have heard of it, but I think that there's something going on with that. could you maybe explain to us real quick what's happening in states and, and federal tax changes, uh, right now with the one big beautiful bill?

Jared Walczak: 0:33

Well, yeah, Kyle, I think I have heard something about this. Uh, I think we can certainly say that of those three adjectives, it is one and it is big and, uh, at least in this case, perhaps beauty is in the eye to beholder. I think that, uh, for states in particular, there are some really good things here. There are some things that people will disagree on. There are some things that I think a lot of us have some real questions about, and that applies to the entire bill, but it also applies more specifically to the tax provisions that at least in some cases, flow through the states. Uh, states typically begin with some version of the internal revenue code for the basis of their own individual and corporate income taxes. They may be up to date on which version of that code they use. They may be lagging. On that. And of course that matters here. They may decouple from certain provisions. Uh, there's lots of different factors that go into this, including, uh, what they use as their starting point of income. But the bottom line here is that there are provisions of the new federal law that are going to affect the states that at least in some states, and in many cases. Almost all of the states are going to change how they tax income as well. That was true of the Tax Custom Jobs Act in 2017. That was true of the Tax Reform Act of 1986. Uh, anytime there's a really big change in the federal tax code, uh, states are paying serious attention.

Kyle Hulehan: 1:53

So. I'm trying to understand that. So Congress can pass a law, they can have federal taxes can change, and that means me here, you know, in New Jersey, I can end up paying more or less on my state taxes without state lawmakers doing anything.

Jared Walczak: 2:08

that's absolutely right. Now, of course, uh, states have the authority under the US Constitution to enact their own tax codes, but for very good reasons. Most states begin the way that they calculate individual and corporate income taxes by conforming to the Internal Revenue code. They want to use its definitions. They want to take advantage of the case law and rulings and regulatory structure. And of course, the. Audits and enforcement capabilities of the federal government when they have their own tax codes and they're doing their TA own tax administration, so they want to be relatively close. They want to be conformed to the internal revenue code. Some states aren't as good as that as others. It's a really good idea, however, to conform. But that doesn't mean you're going to do everything the same. Obviously states for very good reasons, don't have the same rates as the federal government. That would be outlandishly high. Uh, they often have deductions for things the federal government doesn't have, or they add back deductions. The federal government offers, they have their own standard deductions and personal exemptions. Uh, they have certain incentives. They're not the same code, but they're using the same starting point. And therefore, when changes to that internal revenue code, that federal code happen, uh, there's at least a potential. For many of those to flow through to state's tax codes as well, and that's what's happening here.

Kyle Hulehan: 3:26

So should states automatically import every change or should lawmakers, you know, should they try and have the tax code be closer to what Washington's doing? What? How do you see that?

Jared Walczak: 3:36

Generally speaking, conformity is a really good thing. You have individuals, and especially businesses that are filing taxes in many states, maybe pretty much all of them. In some cases, they want definitions to mean the same thing from one state to the other. If there is a determination of how certain income is treated, they don't want different states to treat that income in different ways. Uh, if they are relying on a federal court ruling. Uh, clarifying the matter. They really hope that that federal court ruling also has the same meaning in each of the states, and that they don't have to figure that out separately. And for states, it's also much easier if you can rely significantly on the details that people put on their federal returns, their 10 40 or their corporate income tax returns than. You can rely pretty heavily on the federal audit capabilities and the federal enforcement capabilities. So you want it to be close. That doesn't mean states have to conform on everything, and in fact they don't. They modify it in a variety of ways. They decouple from certain provisions, they go their own way. In important and significant ways, but you use the same baseline and try to speak the same language. And when states fall back, when they decouple for long periods of time, you get enormous complexity. You have states like California that are like a decade behind on tax conformity and it's incredibly challenging. If you are filing in multiple states, especially as a business taxpayer to figure out what exactly is going on in California and how many changes you need to make in all of the determinations you made to sort of decompose it into California tax liability.

Kyle Hulehan: 5:06

So, uh, for example, you know, if, if states are giving up, you know, billions in revenue for a provision like excluding tips, uh, or overtime pay or something like that, uh, that, you know, obviously narrows the, the tax base there are. Are, are these good policies, sound policy? How do you see that?

Jared Walczak: 5:24

States have enacted a lot of tax cuts in recent years. In fact, 28 states have cut individual income tax rates. 15 states have cut corporate income tax rates. Some of them are still going back to that well, and even making further reductions. So there are states that would like to enact further tax relief. But when they do that, they generally want bang for their buck. They want to see that they're getting economic growth out of it, or they want to see that they're providing relief to individuals who need it. And I don't see these as aligning well with that. If we look, say at the new deduction for, uh, tipped income. Or for, uh, premium overtime pay or for auto loan interest. We see provisions that are costly but very poorly designed. Tipped income. For instance, we know that most tipped employees are lower income. Uh, most of them are on the bottom half of the income distribution. So you can see this as perhaps progressive. You're providing a. For lower income filers, but of course not for most of them, right? Like only 4% of the bottom half of the income distribution is people employed in a tipped wage sector. So why are you excluding, you know, 96% of those employees? Why say that someone who earns 35,000 and gets a lot of it from tips. Gets the deduction. Someone who earns 35,000 in a different profession does not, uh, that doesn't make a lot of sense from an equity standpoint and from a state standpoint. If you're asking, does this generate economic growth, does it make our state more attractive for job creation or migration? The answer's probably going to be no. So I think it's very easy to look at this and saying, we're losing revenue. Not getting a lot of bang for our buck. Maybe we wanna decouple from this provision. Maybe we wanna say there's no real benefit. And in fact, there are some significant distortions we may not want in providing a deduction for auto loan interest. That, by the way, skews higher income. A lot of the, uh, you know, auto loan interest, you know, those, this car loan payments are actually middle class and upper middle income families. Uh, but also you're encouraging people to take on. Larger car loans. Is that something the federal, the federal government should have done? Is it something state governments want to do? Are you getting bang for your buck? And I think whether it's the state should just keep this money and use it to, you know, use for its ordinary budgetary purposes, or if you have extra resources and you wanna return it to the taxpayer, could we do it in a better way, a more efficient way? I think those are valid questions. Most states won't bring in these provisions. Um, only the states that begin with what's called federal taxable income. Uh, rather than adjusted gross income, and it's a smaller subset of states would automatically bring in these provisions. But for states like that, uh, states like Colorado, Montana, and Iowa, and a variety of others, these are very active questions. In fact, Colorado is already going into special session to try to address some of these questions.

Kyle Hulehan: 8:11

Real quick, I kind of wanna hit on something that I think is like, uh, an, an undertone of, of what you're talking about here is something about, uh, uh, the government, how choices are made. We don't wanna distort how choices are made. Could, could you maybe just break that down, why that's important for our audience?

Jared Walczak: 8:27

Generally speaking, markets provide the best allocation of resources. Now, markets aren't perfect. Markets don't do everything. There is absolutely a role for government in a lot of ways, but if we are asking how much of their income should people put towards car loans, should they buy more expensive cars or not, that's probably not a decision where you want the government putting a thumb on the scale and saying, we're going to subsidize more expensive cars. Why would we do that? There's really no economic justification for that preference. Not only are you pushing some people towards a decision they wouldn't have made otherwise, but you're also making people subsidize the car loans even if they don't own a car or have owned a cheaper car for many years. Why would we choose to do that? The primary goal of taxes is to raise adequate revenue for government. We generally want to avoid influencing people's economic choices. You can't avoid that entirely. You're raising revenue, you're going to impact economic decision making, but we don't want to do it unnecessarily. We certainly don't want to do it arbitrarily or capriciously. And it's particularly weird when sometimes it feels like with provisions like this, we're pushing, I think, perverse incentives on people.

Kyle Hulehan: 9:37

So. Why, you know, so when we know that, you know, investment incentives like expensing, you know, they drive growth and, and job creations, why would states risk not conforming to federal provisions?

Jared Walczak: 9:51

Yeah, so you've jumped into a new topic. That's really important because there are these personal deductions that are new, um, you know, car loan interest, uh, the higher standard deduction for seniors, which actually runs through the personal exemption provision. That's weird, but we don't need to get into it. Um, the, you know, the. Yeah, tipped wages and, uh, the overtime pay. And then there's the business expensing provisions. And this is a separate cluster and it's really important. This is about, uh, permanent, uh, 100% full expensing, first year expensing for certain capital investments, um, machinery and equipment in particular. Uh, there's a temporary additional provision for certain structures, mainly for factories to also be able to take those costs as a deduction. First year, uh, there's a restoration of what had been the longstanding policy of the United States to allow that first year expensing for research and development, or as the term has actually used research and experimentation, uh, those r and d expenditures. Uh, there's other provisions like this. And you use the term incentive, and I actually wanna push back a little on that. Uh, we, I think, often fall into using that term if there is a provision and we see it as benefiting something, we call it an incentive, but sometimes it's just getting the code, right. Uh, we aren't in this case. Saying We're going to put subsidies or investments towards r and d or for capital investment. There are provisions of the tax code that do that. These, however, are actually eliminating a distortion because when we think about corporate income taxation, the goal is to tax the profits of the business. It is a net income tax. But there are a lot of ways that it's not quite a net income tax. So of course, immediately you deduct the cost of compensation of your employees. You deduct the cost of goods sold, you deduct your ordinary business expenses, but. Under our tax code, you don't immediately deduct all of your capital investment. You have to depreciate your purchases over many years. And that makes sense from an accounting standpoint, right? Like if you buy a$10 million piece of equipment, you aren't$10 million poor. You have 10 million less in cash or in those sort of liquid assets, but you have a$10 million piece of equipment and that counts for something, but it's not profit. You know, you didn't profit, you don't say like, I have a piece of equipment. I'm now profiting from this. Uh, you profit from what comes out of it. But that was a cost of doing business. You wouldn't want to tax that. And in the long run, the federal government and the state governments are not trying to, but they're using. Accounting rules to depreciate the value of that property over time. So you get that deduction in increments over many years. And because of the time, value of money, because of inflation, essentially we're distorting choices. Again, we're saying investment is worse than other things, that you get a disadvantage when you make capital investments. And why again, would we do that? Why would we create any distortion in a field like this? But especially if we were going to have one, why would we distort choices about research and development and capital investment? So these provisions are designed to fix elements of the tax code that have been off for a number of years with that research and experimentation provision, uh, we had had that since the Eisenhower administration from the Eisenhower administration until 2022. You always had first year research and development expensing, and that was great policy. Every state conformed to it. If they had a corporate income tax, the federal government did it. Uh, but as part of the Tax Cuts and Jobs Act, this of course was passed through reconciliation. They needed pay fors. In the out years, they're trying to balance things. They said, we are going to start amortizing this cost, doing a five year depreciation essentially, or a five year amortization really in this case, uh, starting in 2022. And everyone sort of thought, well, that won't actually happen. That's stupid. Why would we let that happen? We're just going to go back and fix it, but there's a cost to doing that. So they didn't do it. And now it's been done. It's gone back to the policy that we had from the 1950s until the, until 2022 for 68 years, and. Some states are looking at this now and saying, wow, there's a cost to this. You know, really a first year cost, because again, you were spreading it out over five years. Now you're pulling it all back into one year. That first year cost is somewhat meaningful. The out year costs are relatively insignificant. It's just that time value of money. So you need to get over a one year hump. And some states are looking at it and saying, I don't know about that. And I think sometimes they're thinking of this as a recurring cost that it's mostly not, but they're thinking by decoupling and I think that's a horrible choice. Every single state with a corporate income tax did this for 68 years at least, assuming they had their corporate income tax that entire time. Uh, they should be going back to it. It's the pro-growth thing to do. It's the pro investment thing to do. If you want economic activity in your state, you want research and development to happen in your state. You don't want to be disincentivizing it. Uh, but since you're looking at that one year cost, and I'm really encouraging lawmakers find ways to get over the hump. To to bear to absorb one year of more cost than you normally have, knowing that it's not very expensive and it's very ordinary and it's what you always had in the future. One silver lining, one thing that makes it a little easier. States, of course were flush with pandemic relief and they've used a lot of that, but they still have some left in most cases, and they're allowed to use it through the end of 2026. That's really convenient. You have a little extra buffer just in this period where you have that one year hit to get back to good policy. I hope states use it. I hope states don't decouple from this important provision.

Kyle Hulehan: 15:12

So then, you know if, if it's smarter for. Lemme say this again, if it's smart oto align with, with, uh, federal policy, you know, uh, how could states and, and what states, are there any states that should, are there anything to carefully decouple from, you know, that might not deliver economic results?

Jared Walczak: 15:31

I think some of those personal provisions don't, and that's not, of course, that we don't care about provisions for individual filers. Uh, we do, but the way to deliver that relief is income tax rate reductions, and that's what states have done. Uh, 28 states have cut individual income tax rates. If there's another state out there that says we haven't done it and we should. Yeah, go do it. Uh, that is the way to provide that relief, not to conform to some of these, uh, maybe more curious. And also, by the way, temporary provisions, like tipped income deductions, that's not going to provide meaningful relief to most taxpayers. It's not going to boost your economy. It doesn't make you more attractive for economic growth or migration or whatever else you might care about. So that's the wrong way to focus on it. If you wanna provide relief, do the rate reductions, but structure really matters in a lot of ways and for businesses. These expensing provisions are basically getting it right. This is how you're supposed to do tax policy. So I hope that states will conform to them, uh, that they won't decouple from them. There's an opportunity for them to align. Now, uh, pretty much every state, really every state conforms automatically to the research and experimentation piece if and when they update their conformity to the post three post reconciliation act version of the tax code. Some states. Actually already do this. They either are so far outta date that they didn't catch this change. Uh, in 2022. A few states are like that, or they realized, Hey, this is bad policy. The federal government's making a mistake. We are going to offer it regardless. So they don't change. But for the rest of states, when they update their conformity or if they have ruling conformity, just automatically they bring this in. I hope they update that conformity. I hope that if they have rolling conformity, they maintain this, don't decouple from it. Other provisions, like, uh, 1 68 K, which is the code section for that full expensing for machinery and equipment. Um, this was offered for the first time under the Tax Custom Jobs Act. There were previous, they called it bonus depreciation. Used to be able to get 30% in the first year, then 50%, and then finally a hundred before it began phasing back down. It's a hundred percent again. Some states about 20 states conform to some version of that. Particularly there are 15 states that do exactly what the federal government does. If they offer 50%, 60%, a hundred percent, they, they do that. Um, there's three states that provide a hundred percent regardless, and there's two states that offer a fraction of what the federal government does, and then the rest of the states with corporate income taxes don't actually provide this first year. If you're one of those states that doesn't. It's time to do it. This is really good policy. It's appropriate, it's how you promote economic investment in your state and how you better align the tax code for growth and get a really bad disincentive out of your corporate income tax. You know, states talk a lot about economic development incentives, and then they have this where they're not providing this. This is, I think. The first step if you really want economic development. Uh, so there's an opportunity for some of these states to conform to the first time or to increase that conformity. If they're only doing fractional in two states, uh, for the rest of states. If they are conforming to this, just please keep doing it. This is good policy. It's worth doing. Uh, don't see it as a way to, you know, pay for something, especially again, where much of the cost is really that first year or so. And then after that, um, there's obviously some additional costs because you are accounting for that time value of money and inflation. You're not making businesses bear these additional unwarranted costs anymore, but it's much, much smaller than the first year.

Kyle Hulehan: 18:52

And now be, before we sign off, I, I just want to say, I, I, is there anything else on this topic that, that you're wanting to hit on? Or did we miss anything here? Any important points that you feel like we didn't get to here? That, that you gotta get in here?

Jared Walczak: 19:05

There's one more thing, and it's really technical, so I'm not going to go into the details, but I just want to acknowledge it. Uh, for really the first time, uh, states began significantly taxing international income when the tax Cuts and Jobs Act was enacted. And that's because there were big changes in how the federal government taxed international income. They actually tax it far less now. But the way they did it, some of the guardrails they put in place flowed through to the states. So there was something called global intangible, low taxed income taxation, and a bunch of states started taxing that. It's poorly designed at the state level. It makes very little sense for states to be trying to apportion a share of the income of, uh, subsidiaries, affiliates, all of the controlled foreign corporations as the term has it, of, uh, you know, US based multinationals to take a share of that for their states. But some states did it. Now the system has changed again. It's called NCTI. It's, uh, net CFC, tested income. That's not a term that we need to really delve into here, but. Only portions of it flow back to the states. So it becomes this really weird system where the federal government is trying to tax basically as a minimum tax. If you paid very little taxes abroad, you pay a minimum tax. Here, the states just tax everything. The minimum tax doesn't work because there's foreign tax credits that apply to account for the, you know, foreign taxes paid, and the federal government accounts for those states don't bring the foreign tax credits in. So basically the states just end up taxing all the foreign income or almost all of it, regardless of how heavily taxed it is abroad. That makes no sense. There's in many cases, no claim of the states on this income. It's. Profit shifting. It's literally the businesses of course, do business in Europe and Asia and elsewhere. And why would a state be taxing that? And what's particularly interesting is, um, such ideological diversity of states. Utah does this, uh, Montana, Idaho, if you had to ask me like 10 years ago, which states would be on a bandwagon of excessively taxing international income, that has absolutely nothing to do with them. I'm not sure if those states would've come to mind. They're very competitive in other ways, but they just never fixed this. They conformed to it and it was bad as guilty. It's worse. As NCTI. Again, really technical. We have some things on our website that go into the details, but if I'm a state lawmaker, I'm going to really ask some questions now about why this is still in my code.

Kyle Hulehan: 21:24

Yeah. Thank you for filling us in on that and, and for filling us in on all of this. This is very informative. I, I think that international stuff, it, it sounds very confusing and, and doesn't make a lot of sense to me, and I think that's correct. It shouldn't make a lot of sense. Um, and so as we sign off here. If you have any burning questions, you can send them our way. You can drop a comment on YouTube. You can email us at podcast@taxfoundation.org, or you can slide into our dms at Deduction Pod on Twitter. you for listening. I.