This post is a follow-up to my post on Professor Amy Mohanan’s article on tax conformity. Amy B. Monahan, State Individual Income Tax Conformity in Practice: Evidence from The Tax Cuts & Jobs Act, 11 Columbia Journal of Tax Law (1) 57 (2020). She derives lessons from state responses to two of TCJA’s big policy changes, the repeal of exemptions and new deduction for qualified business income. When Congress makes major changes in federal tax law, as it did in enacting TCJA, it creates major challenges for states. But major changes like TCJA are rare.
In this post I discuss two second order nagging, conformity problems that are created for static conformity states like Minnesota by Congress’s pattern of enacting:
- Minor tax changes, often late in the year when state legislatures are no longer in session or otherwise find it difficult to respond in a timely manner.
- Substantial tax cuts in response to recessions – the CARES Act is the most recent example – reducing the federal tax bases that states use as the starting points for their taxes (adjusted gross income, AGI, or federal taxable income, FTI).
These problems are not as sexy as those created by major federal changes like the TCJA, but they are persistent. The legislature should be able to make some progress in lessening their adverse effects, but that is easier said than done, as we shall see. As with much of tax or any public policy, it comes down to the art of finding a second best policy that politicians can support and sell to voters. Spoiler alert: it’s not clear to me that there is one in this case.
The post consists of four parts:
- A short description of congress’s frequent and tardy enactment of tax law changes that make it difficult practically for static conformity states to keep their taxes in synch with federal definitions, often not until well after filing of tax returns has started.
- My take on why political considerations make it difficult for states to respond, even when they have time to do so. The result is chronic complication of state tax compliance and administration for little reason.
- A description of two ideas to mitigate these problems – one is my modest proposal to defang extenders that has been considered, but not enacted, by the Minnesota legislature, the other is a wild-eyed proposal that is useful only as a thought experiment.
- An obligatory coda that points out, even though it seems like yelling for the wind to stop, that Congress should clean up its act.
Congressional tax legislative process creates problems
Congressional tax practices over the last 20+ years have made life difficult for state tax policymakers, administrators, and taxpayers generally; this description duplicates much of what Professor Monahan outlines in her more detailed and nuanced account.
- As a practical matter, state corporate and individual taxes must be linked to the analogous federal taxes. States link their taxes to some measure of federal income – typically AGI or FTI. State additions or subtractions address policy and revenue preferences that differ from the federal rules. State rates and credits determine tax. It is not realistic for a state to require taxpayers to deviate very much from federal computations of income, particularly for businesses that make capital investments or operate in multiple states. Income taxes in one year can affect a later year, particularly a myriad of multiyear business income provisions. Individuals may work in multiple states in one year or move from state to state over time. Retirement plans (401(k)s, IRAs and so forth) are administered by national financial institutions, following federal rules; they’re not likely to accommodate state-specific rules, particularly for small and medium sized states. Deviations from federal rules create record keeping and computational hassles for taxpayers. Bottom line: states are stuck with largely following federal rules for multi-year and more complex income computations.
- Static conformity states link to a time-specific version of federal law. The Minnesota Constitution to some unclear extent requires that tie to be made to preexisting federal law, so that Congress cannot change Minnesota law. That means each time Congress changes the rules for calculating the relevant version of income, a static conformity state is out of conformity until its legislature adopts, modifies, or rejects the change(s). That system would work well if federal law were stable and only rarely changed. That was true in the distant past. It is not now.
- Congress frequently changes federal law. These changes are often made near the end of the calendar year and apply to that tax year. Congress commonly does that to continue expiring federal tax provisions (“extenders”). The staff of the Joint Committee puts out a annual list of the expiring tax provisions, available here (note that this includes the traditional collection of extenders, as well as the TCJA individual provisions that expire later this decade). Congress uses expiring provisions to game its 10-year budget rules. There is no policy or administrative justification for the practice. In an ultimate act of budgetary cynicism, Congress enacted an over $1 trillion tax cut in TCJA but left many of these minor expiring tax provisions unresolved as to their permanency and provided a large group of TCJA’s individual income tax policy changes expired (12/31/2025) to play that budget game at a higher stakes, partisan political level. A couple months later it began anew with the periodic extensions of the old extenders.
- In addition to the problem of extenders, whenever a recession occurs (exception: 1990-91 recession), Congress turns to enacting Keynesian stimulus, which thanks to GOP tax aversion, is typically heavily weighted to tax cuts, rather than more government spending. These federal changes could not come at worse times for states; they must balance their budgets and recessions reduce state revenues, while often increasing state spending on various social service programs.
- Two chronic conformity problems result; the first is a matter of timing. Federal extender legislation is often enacted after state legislatures have adjourned and take effect before the next sessions reconvene. For example, the Minnesota regular session ends in May and the federal changes are usually enacted in the late fall (November or even December) and often apply to that year. As a result, it is physically impossible for many static conformity states to keep up with the federal changes. (The IRS itself can barely do so.) They cannot modify their state laws in time to change tax forms, in some cases, even if they had the political will to do so. As a result, state returns for affected taxpayers must be filed based on prior federal law. If the legislature later opts to conform to the federal changes (perhaps because they are for multiyear provisions that it is not practical to deviate from federal law or because politics dictates doing so), amended returns must be filed or in some cases DOR can recalculate the tax due and send a refund or balance due bill. This dramatically increases compliance and administrative costs.
- The second is a political and budgetary one. Extender changes are almost always revenue losing (remember Congress is gaming its budget rules which are intended to prevent increases in the deficit). By definition, tax bills enacted in response to recessions similarly reduce revenues, often substantially. Conforming to either, thus, causes a reduction in revenues, a tax cut. States, of course, cannot run deficits, so they must find real budget resources to offset the change. In the case of extenders, taxpayers often consider these provisions to be the default. After all, they typically were the law the last time they filed. Allowing them to expire or offsetting them with balancing rate increases would be perceived as a tax increase, even though that may not be technically true. For recession response tax cuts, state are simply not in budgetary positions to finance conformity-based tax cuts.
State political realities make responses difficult
In a perfect world, legislatures in static conformity states would respond to this congressional disfunction by quickly enacting conformity legislation when they are back in session – at least for minor changes like the typical extenders bill. In some years, they might be able to do that soon enough to allow the state tax administrators to revise forms with minimal complications and delays for taxpayers. Since the federal changes are relatively minor revenue losers, offsetting adjustments (e.g., rate changes) could be used to make up the revenue loss if the state budget is tight. For extenders and similar minor changes, they would be so small virtually no taxpayer would notice. If legislatures were simple technocratic institutions, the federal dysfunction would be little more than an annoyance that must be dealt with by regular adjustments made under tight timelines.
But state legislatures are not technocratic problem-solving institutions, but rather are political (highly so, some would say) and finely honed political considerations and political poker playing get in the way of what seem to be simple solutions. To be more explicit, the following six factors tend to make conformity legislation for relatively minor federal changes like the extenders a “political orphan” of sorts:
- As noted above, conformity legislation is almost always revenue reducing and state budgets must be balanced. So, conformity “tax cuts” must compete against other budget priorities – other tax cuts and spending. If the budget is tight (e.g., there is little or no surplus), the competition can be intense, even for small amounts.
- Tax simplicity and understandability, the prime policy benefits of conformity for these minor extender bills, do not score highly for partisans of either stripe. Thus, neither side is inclined to fight for conformity as it competes with other more sexy or politically compelling priorities their partisans are salivating for.
- To make matters worse, the typical minor conformity bill involves provisions that have already been in effect, thanks to extenders. The few taxpayers that benefit expect them to continue; they probably assume that they are permanent features of the law. So, keeping them in place yields little, if any, political juice. Of course, it they lapse, affected taxpayers will think someone increased their taxes, creating a true no-win situation. When this happens because of gridlock (see #5), the parties get religion for a few years and enact conformity bills, separately if necessary – when there is enough budget room. But they tend to lapse back into old patterns.
- This results in a political poker game where each party seeks to make the other pay. The most common assumption is that the administration, which administers the tax system and bears the political costs and risks of tax administrative dysfunction or failure, has the greatest interest in conformity. But recent administrations (all of those in the 21st century) have been unwilling to “pay for” conformity in the end of session budget negotiations. (Why that is so is a mystery to me; I have guesses but that is all they are, guesses. The most poignant example to me was 2013 when the Democrats controlled both houses and the governorship. The administration and House included conformity legislation in their tax bills, but the Senate did not. I assumed that was because Senators Bakk and Skoe assumed that they could extract concessions from the House in conference negotiations. When that is exactly what played out, the administration/governor did not insist on conformity as a third party cop in the negotiations. The House refused to give up on some of its more political priorities and the final deal did not include conformity. When the practical realities of that decision played out in the summer and fall, everyone got religion and resolved the matter in 2014, but the hiatus was painful and costly – both in terms on unneeded complexity and politically, I believe.)
- Because tax cuts are the central or defining principle of the Republican legislative caucuses and politics are very polarized, enactment of tax bills in recent sessions has become more difficult in Minnesota. The Democrats in some recent sessions have concluded that it is easier to simply refuse to agree to an omnibus tax bill. When the governor is a Democrat (as has been the case for the last decade), Republican legislators assume that a conformity bill is something that is important to the administration (see #4) and hold it as negotiating bait, a condition of getting a tax bill. But recent Democratic governors are rarely willing to spend any of their political chits to buy good tax administration and simpler compliance. (See ##2 and 4 above.) They may think this is just a matter of “good government” (i.e., it does not move their own political agenda forward) and that they should not have to pay a price for it.
- None of this would be a problem, if making offsetting tax changes, such as rate and bracket changes, to allow conformity to be enacted on a revenue neutral basis were considered a reasonable option. It’s not. Conventional wisdom, especially among Republicans, is that offsetting changes are tax increases. (They are on a taxpayer-by-taxpayer basis but not overall or even for purposes of Grover Norquist’s idiotic “no new taxes” pledge!) The expectation by both sides is that they will be used in political campaigns as such – showing up in campaign flyers and mailers: “Representative X voted for a tax rate increase of Y.” As a result, there is great reluctance to use this sensible “revenue neutral” approach in the name of simplicity and ease of compliance and administration. This applies on an even larger scale for federal tax bills enacted in response to recessions. In those case, the rate increase usually would be sufficient for taxpayers to notice and could materially shift the tax burden, often from businesses to individuals, a very heavy lift politically even if one thinks it makes policy sense.
These factors (and others I won’t waste even more space and time going into) tend to overwhelm the ability of the Minnesota legislature to respond, at least quickly and sometimes for one or two years to even minor federal tax bills, like extenders. I expect (but don’t know) that the same dynamic plays out in other state legislature, varying depending upon local politics. The net result, in my mind, is a more complicated and expensive tax system for little legitimate state tax policy reason. The proximate cause is dysfunctional and short sighted politics at both the federal and state levels.
General background on my two ideas. In thinking about the challenges conformity presents for the Minnesota state tax system over the years, I have come up with two ideas for addressing the problems. The first is a modest proposal that focuses on the irritation and timing nuisance of regular passage of federal extenders when the legislature is out of session effective for that tax year. As noted above, gridlock occasionally makes it more than a timing nuisance with a few examples of the passage of a full year without enactment of conformity legislation. In any case, this modest proposal has been drafted into specific legislative proposals and, in one case, passed the House but did not survive conference committee. I briefly describe how it works and why I think it makes sense – at least as a practical administrative matter, in my view.
By contrast, I have never publicly described my second or “big” proposal and, in fact, have never tried to flesh out exactly how it would work. It is intended to address the more systematic and deeper problem, in my view, that Minnesota has persistently not conformed to federal depreciation/expensing rules – specifically, section 179 and bonus depreciation – and the conformity challenges of recession response federal legislation, such as the CARES Act. (Minnesota’s nonconformity to section 179 and bonus depreciation started with it failure to conform to the second Bush tax cut, Jobs Growth and Tax Relief Reconciliation Act of 2003, which was enacted partially to respond to the 2001 recession.) For reasons I explain below, I think the failure to conform to federal capital cost recovery rules is problematic. Others don’t agree and Minnesota has lived with the failure to conform for long periods now and episodically on NOLs. So, maybe it’s not as big a flaw as I think. My proposal is conceptually simple but has technical challenges, aside from shifting tax burdens around. It is intended as a thought experiment, rather than a viable proposal. I know the politics won’t work.
Both proposals rely on moving Minnesota from a pure static conformity state to something of a hybrid model that provides for automatic updates or conformity on some federal provisions. (Disclosure: to my knowledge, no other state has done anything like this.) That obviously raises constitutional issues under the Wallace case, which dictates that Minnesota be a static conformity state to avoid delegating state legislative power to Congress. I believe those constitutional issues are not an insurmountable barrier – especially for the modest proposal, less clearly for the big proposal – but I will not go into a legal analysis of why I think that is so. Doing so would be a waste of time. The big proposal is sufficiently radical that it will not be seriously considered, while I’m sure the modest proposal is constitutional and if enacted is unlikely to be challenged (lack of standing, not worth the effort, etc.).
The real problem with both ideas is political. Elected officials obviously do not consider tax administration and compliance problems with lack of conformity to be important enough to commit budget and political resources to address them. At least, that is the message I have gotten over the years, despite my privately hectoring House committee chairs and other members about it. What seems even more remarkable to me is that recent commissioners of revenue (at least the last three) do not appear to have gone to bat urging the governor and legislature that conformity with its benefits of simplicity and ease of compliance are sufficiently important to justify committing modest resources to it.
A modest proposal on extenders
After it became apparent that extenders would be a persistent congressional practice and that the legislature was having difficulty quickly responding, two of us (I’ll protect the innocent by not naming the other person, a DOR employee) tossed around how we could address the disruption they caused to DOR, tax software providers, and taxpayers. The legislature routinely conformed to extenders but often too late to avoid the headaches of preparing forms assuming nonconformity and early filing by taxpayers assuming that as well. This resulted and will continue to result in thousands of hours of needless work; regular deadweight losses in the millions of dollars in economist speak. A wild guess would be that these costs equal 5% to 10% of the tax revenue involved with extenders. The obvious problem was the limitations imposed by Wallace’s apparent requirement of static conformity and the fact that the legislature was out of session when Congress acted. Partisan gridlock and one or the other caucuses or houses (almost always the GOP or Senate) trying to leverage conformity for unrelated tax concessions. This sometimes caused multi-year delays, increasing the disruption and cost.
After a little discussion and thought, the solution to the two of us seemed obvious and easy to accomplish – mechanically and legally:
- Mechanically, it could be solved by passing a law that conforms to extenders on a dynamic basis – i.e., specifically listing each extender and providing that it is in effect for Minnesota purposes, if it is also in effect for federal purposes. That obviously creates the possibility/probability of an unfunded future tax cut, creating state budget problems. (An aside: the magnitude is usually relatively small, in the $15 million to $25 million range per year, but that is still real money in a tight budget.) To address that, a standing (ongoing statutory) appropriation could be provided to a dedicated account that would fund the tax cut if congressional action triggered the contingent extenders. To make sure the account balance was adequate, triggering Minnesota conformity to each of the extenders could be made subject to administrative approval by the commissioner of DOR. To control the commissioner’s discretion, the legislation could specify exactly what order the commissioner would do this in. That would prevent the commissioner’s preferences from determining which provisions went into effect if the account’s balance were too small.
- Legally, this almost surely does not violate Wallace’s prohibition on delegating legislative power to Congress. The legislature itself is explicitly deciding which provisions will apply for Minnesota tax purpose, so Congress is not making the decision. Yes, the effect was contingent on future federal action, but that is just a policy judgment by the legislature that it wants the provisions to be in effect only if they also are in effect federally.
The solution works mechanically and legally. Unfortunately, its political appeal and, hence, the feasibility of its enactment were another matter. I drafted the bill in 2015-2016 and it was introduced as H.F. No. 2875 in the 2016 session by Representative Rosenthal and 15 coauthors and received a hearing. But that was the end of it.
Actions in the 2017-18 session were slightly more positive. A revised version was introduced by Representative Paul Thissen as H.F. No. 816 and it was included in the House version of the omnibus tax bill, H.F. No. 4, art. 1 § 15 (3rd engrossment)(main section only). However, it did not survive conference committee (no surprise). I was told privately that DOR attempted to get the mechanism include in Governor Dayton’s budget but failed to do so, largely because of opposition from MMB because of its fiscal implications. That probably was its death knell, since it had no one advocating for it in conference as a result. Its author and main legislative proponent, Representative Thissen, was a Democrat and the conference committee consisted entirely of Republicans. Moreover, as I will detail in the next paragraph, its political appeal is limited so its support must come from DOR and the administration. The failure to include it in the governor’s budget, thus, sealed its fate.
Lack of political appeal. It is difficult to convince legislators to opt for the provision for a couple of simple reasons. The dedicated account requires them to use scare fiscal resources, as passed by the House in 2017, $35 million in biennial funding, and they have much more politically appealing ideas for using that money:
- The use of the fiscal resources for the extender account is not compelling (to put it mildly). It will pay for potential future tax cuts (the extenders). But they are already in place and the average beneficiary of the provisions assumes that they are permanent or will continue. Moreover, there is a remote chance Congress will not renew them, so a member cannot truthfully represent (e.g., in campaign literature) that he/she provided tax cuts.
- Real or sure tax cuts are more compelling. If you favor tax reductions, as the then majority GOP legislative caucuses did, alternative uses of the money are more compelling. You’d rather say that you used it to help families saving for college with tax credits and deductions, individuals paying off student loans with a tax credit, first time farmers with a tax credit, individuals saving to buy a home with a deduction, and business property owners with a tax cut (all of which were enacted in the 2017 bill).
- It will be harder to claw back than spending. The administration’s opposition, which preemptively resulted in the proposal’s still birth in my judgment, likely derived from the fact that the proposal committed fiscal resources to ongoing tax cuts (i.e., conforming to likely extensions of the extenders). The administration was not interested in funding tax cuts, even if they were temporarily already in place and would simplify administration and compliance by a lot. Moreover, the MMB professional budgeteers (who were a source of opposition) surely recognized that it is fiscally easier for Democrats to dial back increased spending than to defund an account that is legally dedicated to tax cuts – the GOP would charge them with a dreaded tax increase. Thus, they likely (and accurately) considered it more fiscally risky for long term state budget solvency.
Bottom line: It is easy mechanically and legally to fix the extender problem but politically difficult. An insistent governor could put it across, but at some political cost. I would not hold my breath.
A more ambitious solution (thought experiment)
Background: why I think there is a significant problem that should be addressed. I see two more systematic and bigger problems with federal conformity. The first stems from the state’s failure to follow federal cost recovery rules – i.e., bonus depreciation and section 179 expensing. Decoupling from federal depreciation rules occurred briefly in the early 1980s following passage of the 1981 Reagan tax cut, Economic Recovery Tax Act or ERTA, and more recently and seemingly permanently with bonus depreciation and expanded section 179 allowances. The state declined to conform to various federal acts during the Bush administration that adopted these provisions temporarily and ultimately the TCJA which made many of them permanent.
Note: Since I wrote this, the legislature in the fifth special session conformed to the § 179 rules. But that does not really change my thinking or the points I’m making. It took over 15 years to fix the nonconformity and, then, only because of the unusual circumstances (i.e., TCJA’s like-kind exchange provision). Bonus depreciation nonconformity looks likely to continue in perpetuity.
I think the failure to conform to section 179 and bonus depreciation is a serious problem:
- They make record keeping, tax compliance, and administration of the law complicated for taxpayers and the government. These are multi-year provisions that affect basis calculations, including potentially inside and outside basis for pass through entities. The costs of this complexity, largely invisible because they are never tallied up, are substantial to taxpayers and the government.
- To minimize complexity for bonus depreciation and section 179, Minnesota developed a simplified system allowing recovery over a 6-year period, rather than in the year made. That minimizes record keeping requirements and complexity a little but at the cost to some taxpayers of the ability to claim allowances for these expenses at all and in other cases taxing phantom capital gain. The former occurs because deduction may be allowed in a year when the taxpayer has zero or negative income and the simplified method does not include carryback or carryover provisions. Proposals have been made to correct that but have not been enacted – the recently enacted legislation conforming on section 179 does not address it, for example.
- These rules and their obvious inequity likely result in uneven compliance – I would guess (without any direct knowledge) that in some audits DOR allows basis adjustments because of the inequity of taxing phantom income and to avoid litigation under its general administrative authority. In other cases, taxpayers likely make self-help, extralegal adjustments and are not audited, while other taxpayers simply pay the tax, perhaps, without even recognizing what is occurring.
I should note, however, that others apparently do not think a state using its own depreciation rules is a problem. See, e.g., Darien Shanske, Adam Thimmesch, and David Gamage, Strategic Nonconformity, State Corporate Income Taxes, And the TCJA: Part II, Tax Notes State, 123, 124 (July 13, 2020) (“decoupling from section 168(k) is the easiest and most straightforward path for states to follow during their budget crises”); Ruth Mason, Delegating Up: State Conformity with the Federal Tax Base, 62 Duke L. J. 1267, 1229 – 30 (2013) (characterizes not following federal depreciation rules as having “great administrative cost” but is not in her category of federal provisions that are “practically nonseverable” such as the realization requirement).
Why the legislature failed to conform to the federal rules is easily understandable – at least to me, since I was advising legislators when it occurred. These rules were initially adopted when Minnesota had an extraordinarily tight state budget (2003 – 2006), so it was not practical to conform and absorb the revenue loss, which was significant. Moreover, legislators were unwilling to make tax changes (e.g., a rate increase) to offset the revenue loss. Such a step was unpalatable politically as a visible tax increase on individuals to reduce taxes on businesses. As a result, the 6-year allowance was developed as a compromise that avoided the revenue loss (not technically true but I won’t get into that) but was still simpler than requiring the old depreciation rules to be followed on a property-by-property basis. The law could be modified to allow full basis adjustments and carryovers to avoid the problems I identified. But that would further complicate matters.
The second serious conformity problem stems from Congress enacting business tax relief provisions in response to recessions, typically (again) in cost recovery or depreciation rules but also in the timing of when losses may be deducted, such as net operating loss provisions. The recent enactment of the CARES Act is a good illustration (similar changes were made in 2008-09). It temporarily reversed TCJA’s NOL provisions and its prohibition on using large active business losses to reduce other income. The timing of the enactment of these provisions occurs exactly when state budgets, which constitutionally must be balanced, cannot fund conformity tax cuts. The 2020 legislature deadlocked and ignored how to respond to the CARES Act. The 2021 legislature will need to face it and it will not be an easy choice. (The 2009 legislature also did not conform to the federal NOL changes enacted by Congress to respond to the Great Recession.)
Failure to conform to these timing provisions also creates multi-year record keeping and filing difficulties. This will create basis differences for pass through entities. The revenue involved for Minnesota according to DOR estimates is more than $300 million (DOR estimate). If the legislature were willing to raise rates to eliminate the revenue loss, that would shift the burden from businesses to individuals in a material way. That is an obvious political nonstarter, and it would add insult to injury for individuals, many of whom are also suffering economic hard times too.
In sum, I think it would be especially useful if a solution could be devised that minimizes the complexity, compliance, and administrative problems without reducing state revenues, while minimizing the shift in burdens among groups of taxpayers. That is the goal or the needle my proposal seeks to thread. I recognize it is a bridge too far as a political matter (and maybe as a technical matter, since I am not willing to work out all the details). So, it is mainly a thought experiment.
Outline of proposal
Given these challenges/barriers the obvious solution to me is to separate business taxation from that of wage earners, passive investors, independent contractors (who are often little different than wage earners), and similar. In short, to go to a schedular system of taxation for business income that is in dynamic conformity with federal law. (Other countries, like the UK, have schedular systems. Arguably the lower federal capital gains rate is a quasi-schedular system.) Then, automatically adjust the rate to hold revenues constant. Here are slightly more specific descriptions of the elements I would use to do that:
- Subject business income to the corporate tax, rather than the individual income tax. That would apply to pass-through entities and sole proprietors who claim material depreciation allowances (in other words, not independent contractors who are de facto wage earners in many cases). I won’t elaborate on the technical way I would separate the sheep from the goats. That would take pages of details – some of which, to be fair, I haven’t worked through.
- Exempt that income from the individual income tax. That would be done via a subtraction from AGI or an addition if their business income is a loss and reduced other income, like wages or investment income.
- Allow subtraction of a flat amount to compensate for the rate structure of the corporate franchise tax. I don’t know what this amount should be, but probably on the order of $25,000 to $50,000. It would be a function of where the revised corporate rate ends up (next item) and how much relief one wants to give to low profit “small” businesses. This would not apply to C corporations, obviously.
- Fully conform to federal cost recovery allowances and other timing issues on a dynamic basis, such as bonus depreciation and loss allowance rules, other than NOLs, under federal law. There are obvious and serious legal questions as to the constitutionality of this. I think a reasonable case can be made for it as I briefly suggest below. (Note: Minnesota corporate tax has its own NOL regime, so that causes that timing difference to go away. The same would occur with regard to TCJA’s active business loss provision that the CARES Act reversed for a period of time. Moving business income to the corporate tax would prevent active losses from offsetting wages or passive investment income. It might make sense to conform to federal NOL rules for corporate purpose under my option, but the apportionment formula for the relevant year would need to be applied reducing the simplicity advantage.)
- Allow recovery of previously disallowed bonus and section 179 amounts over the same period as allowed under present law. In addition, until this is done, I would provide basis adjustments and carryovers.
- Reset the corporate franchise tax rate to adjust for these changes. This would hold state revenue constant for all the various base changes. The rate would be reset each year until the phase-in of the disallowed amounts was done.
- Direct DOR to adjust the corporate franchise tax rate to hold revenues constant each time Congress passes a law that dynamic conformity reduces or increases revenues by a non-de minimis amount (e.g., by more than $10 million per year). This would be done annually, so that phase-ins, temporary provisions, and similar are accounted for.
- Make special accommodations for farms, since they routinely use farm losses to reduce tax on other income and it will be politically impossible to change that for any except (maybe) the very largest operations. (Dealing with farms and farmers is the bane of anyone trying to put together a major income tax restructuring proposal.) An exemption from the entity tax would need to be carved out for small to modest sized farms, so they can continue to use farm losses in bad years to reduce wages and investment income. (Wags have regularly observed that the state might be better off fully exempting farm income from taxation, implying its inclusion’s predominant effect is to reduce tax on other income – probably not true but it occasionally seems that way.) That creates the headache of how to treat their cost recovery under the individual tax. One approach would allow those paying under individual income tax the option of claiming cost recovery under whatever the federal rules are (dynamic conformity) or under the static conformity rules but without any special carryover or carrybacks. Obviously, I haven’t given the serious thought to the treatment of farmers that would be needed if this were a serious proposal. Taxation of pass through entities providing personal services (e.g., doctors, lawyers, accountants, etc.) is another trickey issue that would need to be addressed in a real proposal.
Observations: pros, cons, and lack of political viability
This system for pass through entities and some proprietors would be a big change. The bigger issue is that it would be a tax increase for some businesses that do well under the current system and it has legal issues. Here are some of the considerations that appeal to me about it (of course, it was my idea) or that don’t:
- Most of the complexity of the current system results from timing differences, loss carrybacks, capital cost recovery, and so forth. In this very low interest rate environment (where time value of money issues are not as a big a deal), it makes sense to me to simply follow the federal rules on timing and keep matters simple.
- Using the corporate franchise tax rate – a flat rate – fits into that scheme, so timing issues do not cause rate arbitrage. The income will be taxed at the flat rate that applies to all businesses, regardless of when it happens to be recognized.
- This also (only partially) helps address the issue of the preferential taxation of pass-through entities, as compared to C corps. Many of these are very big businesses. They still get a big break in that their income is taxed only once, unlike owners of C corps who pay twice – okay, a lot of C corp stock is owned by foreigners, retirement plans, and other tax exempt entities but still. (A constant source of irritation to me are the claims by pass-through businesses and their various representatives that the individual income tax is their “business tax.” It is not. It is a personal tax, equivalent to what investors and wage earners pay on their dividends, capital gains, and wages. They do not pay a business entity tax. This won’t fix that, but it moves in the correct direction by imposing the higher, flat corporate rate.)
- The obvious practical problem for state government is the revenue hit from conformity legislation. Automatically resetting the rate to hold revenues constant solves that problem.
- Does it violate Wallace and the prohibition on delegating legislative power? I don’t know but think that there is a reasonable chance it does not. One could do a careful legal analysis – parsing the language of the Wallace opinion, looking at other Minnesota cases and those in other states on delegation of legislative power, considering the policy ramifications in light of constitutional legislative power, etc. – but it’s not worth the effort. I say that as one who spent a lot of time and effort writing legal memos opining on similar questions – often feeling my efforts were not worth the paper they were written on. On these coin-toss type issues, it will come down to how the current members of the court react to the practical reality that the system (1) does not delegate to Congress the ability to raise or lower overall Minnesota taxes, just the ability to determine the year they are due for different businesses, (2) fosters simplicity and ease of administration by conforming to a complex set of federal rules, but (3) may shift around quite a bit when and exactly who pays business taxes. The only way to definitively find out would be to enact it and wait for an adversely affected taxpayer to sue. If the increasingly conservative U.S. Supreme Court turns to the anti-delegation doctrine to strike down federal legislation (a distinct possibility). That could stimulate a counter-reaction by an increasingly liberal Minnesota Supreme Court narrowing the doctrine, to suggest a weird aside.
- The structure likely would allow owners of pass-through entities to deduct the tax (over the $10k limit in TCJA) in computing their federal individual income taxes. Business groups have proposed (and some states have enacted) similar structures, except taxpayers would be allowed to choose whether to be subject to the entity tax. Whether these voluntary arrangements are successful in working around the TCJA limit remains to be seen. A mandatory system like the one I suggest is more likely to be successful, I would assume.
- There will be technical problems in determining which taxpayers with business income are subject to the corporate entity tax. If some taxpayers with depreciation are allowed to continuing paying under the individual income tax (likely necessary to avoid subjecting businesses with very simple situations to the entity tax), then it will need to provide a way to allow those deductions, the mess the system is designed to avoid. How should personal service corporations (law firms, accounting firms, etc.) be taxed under this arrangement – should it depend upon whether they claim depreciation? If there isn’t a hard and fast, bright line rule, should businesses be allowed to toggle back and forth?
- Minnesota owners of multi-state pass-through businesses will receive a tax cut, since their out-of-state income (determined using sales apportionment) will no longer be taxed. This will force the revenue neutral rate higher and will raise fairness issues and wave red political flags for some legislators because it may be perceived to encourage out-of-state investment.
An idea along these lines will not be politically viable because:
- It will create winners and losers (some by substantial amounts). Real estate developers and owners come to mind as losers. Losers will complain and lobby against it; potential winners will remain oblivious or silent. Experience says that there is little legislative appetite for creating losers for minor benefits like simplicity and reducing compliance costs. One example serves to illustrate. As I noted above, nonconformity on section 179 and bonus depreciation have persisted for a long time and the business lobby has always expressed support for conformity, but that support is tepid. They would perfunctorily testify in favor of conforming, but when it came to actual lobbying for it they were MIA as far as I could tell. Instead, they routinely put their lobbying muscle behind cutting the state C/I property tax? Why – when, in theory, conforming on bonus and section 179 should be so much more appealing? (In my mind, two simple reasons for that greater theoretical appeal – (1) The first is a lobbying advantage. Conformity would provide businesses a simplicity dividend in lower tax compliance costs and those savings don’t show up as a state cost on budget spreadsheets, so you don’t have to pay for them in legislative lobbying battles. Thus, it makes getting tangible benefits for your clients cheaper and easier. (2) The second is a policy advantage. Conformity focuses the tax cuts/benefits on businesses that are investing and expanding their operations, providing consistency with the “job creator” rhetoric the business lobbies consistently use. By contrast, cutting the state property tax gives money mainly to anyone who owns or rents C/I real estate – overwhelmingly, old fixed capital, which economic theory and common sense says will do little to encourage investment or economic activity. You may as well hand out money on the street corner.) Conforming to section 179 and bonus would be a business tax cut that doesn’t create losers, but it is still not preferred because the business organizations’ (Chamber mainly) dynamics encourage pushing policies that benefit all their members (every business owns or rents C/I property), not just those investing in equipment and machinery. A policy that creates losers, like my wild idea, creates political challenges that are several magnitudes more difficult than conformity as a tax cut.
- There is likely to be inherent skepticism about DOR accurately setting the revenue rates.
- The business community probably thinks it would be giving up using conformity as a political wedge to reduce or hold down business taxes. If that is what they think, they’re likely wrong; they haven’t been able to use it as leverage for anything in recent years.
The proposal illustrates that the current system – a product of congressional dysfunction, legislative dysfunction, and Wallace (maybe) – imposes large administrative and compliance costs when all that is going on are largely matters of timing, determining in which year tax will be paid on business income. When Congress enacts business tax base reductions to respond to recessions, the state struggles to hold its revenues constant by refusing to conform and, in the process, imposes large compliance and administrative costs that benefit no one. Wouldn’t we better off by just following the federal rules and adjusting the rates to hold revenues constant at roughly what they would have been under the existing system? The total tax would not change, while less time and expense would be spent by both businesses and the state in computing, paying, and collecting the tax.
Coda: Obvious solution lies with Congress
I admit this a pure pipe dream. But fixing the problem at the federal level is conceptually easier, even if it is politically impossible. Professor Monahan focuses on how states can change their practices to adapt. I understand that, since congressional practices frozen in partisan gridlock and interest group lobbying, seem immutable. Of course, working for a state legislature that always was also my focus. But the real source of the problem and the easiest path to a solution lies with Congress. Others have made these points well, but I can’t resist. See Professor Ruth Mason’s recommendations for Congress as a good example. Delegating Up: State Conformity with the Federal Tax Base, 62 Duke L. J. 1267, 1338 – 43 (2013).
If it were a good federalism partner, Congress would consider the impact of federal tax legislation on state tax systems. Specifically, it would three things:
- Get off the extender treadmill. This is a no-brainer, given that it is fostered by gaming the scoring system and both parties now appear to have given up on minimizing the deficit as much of a factor in federal budget policy. One could cynically assume that extenders are simply a way to generate campaign contributions from the affected industries. I’m not that cynical, but the practice sure smells fishy. Why Congress did not make the extenders permanent or repeal them as part of TCJA is particularly odd. You’re cutting taxes by $1.5 trillion and you cannot figure out how to resolve extenders, leaving them hanging in limbo?
- Refrain from enacting tax changes that apply to the year in which they were enacted – giving states time to deliberately consider them. I recognize that there are downsides to this. For example, delaying more generous depreciation rules could cause businesses undesirably to delay new capital investment until they can benefit from the new rules. A temporary, transition investment tax credit could mitigate that.
- Enact most federal tax expenditures as tax credits (ideal) or below-the-line deductions (second best) to avoid disturbing state taxes, most of which are linked to AGI. That would give state legislatures the choice of whether to amplify a federal tax expenditure by adopting a companion state provision or to forgo it, but without complicating the state tax. For example, if Congress seeks to stimulate capital investment, the old system of an investment credit, rather than expensing (a la bonus depreciation and section 179) would be ideal.
- Tax cuts enacted as Keynesian stimulus in response to recessions should be done as rate cuts or tax credits to reduce stress on state budgets. Aside from the adverse effects on state budgets, the wisdom of providing loss carrybacks is questionable as a form of stimulus. They are not structured to clearly stimulate either consumption or investment. Better mechanisms can be designed. That, of course, is a topic for another day and for someone with more economic expertise than I have.
I know none of this will happen – okay, maybe Congress will trim the list of extenders a bit as it has done recently – but I still felt the need to say it.