The Effects of Federal Tax Expenditure Policy on the States

At a time when states are desperately struggling to balance their budgets, one source of additional revenue has been overlooked: decoupling state tax policies from federal tax policies to modify deductions and credits that reduce citizens’ state tax liability. While forty-three states and the District of Columbia tax personal income and have the freedom to deviate from federal tax codes, almost all of them mimic federal tax provisions. It is true that there are several benefits derived from “piggybacking” on the federal system, including ease of enforcement, simplicity for taxpayers resulting from uniformity, and decreased administrative costs. However, there are also costs involved in piggybacking: states cannot respond to the special needs of their citizens, do not experiment with innovative policies that might prove beneficial, and lose significant amounts of revenue by adopting policies such as the home mortgage interest deduction. This Article considers the influence of federal tax expenditures – provisions not aimed at measuring net income – on the states, focusing on tax expenditures in the areas of health care, retirement savings, and homeownership, and surveying how states conform to or deviate from the major federal tax expenditures in these three areas. This Article finds that states tend to adopt those tax expenditures structured as exclusions and deductions but are less likely to adopt tax expenditures structured as credits. It concludes by proposing reforms to decrease the bias towards exclusions and deductions, promote transparent state tax expenditure policy, and thus encourage more innovation in tax policies at the state level. These reforms include imposing a federal reporting requirement for items excluded from gross income, reforming state tax expenditure budgets, and adopting new federal starting points in the calculation of state taxable income