By Michael Lucci, Senior Policy Advisor, State Policy Network
Thanks to the American Rescue Plan Act (ARPA), $350 billion in federal funding is headed to state and local governments for pandemic recovery. States and local governments must now prepare to use the funds in a way that encourages growth and sustainability. A Treasury Department statement released on April 7, 2021, just might open the door to state tax reforms that will benefit local businesses and communities looking to recover—and thrive—after the COVID-19 pandemic.
The American Rescue Plan Act (ARPA) distributes $350 billion to state and local governments for recovery from the coronavirus pandemic. This money is a windfall for state and local governments—the funds dramatically exceed revenue losses attributable to the pandemic recession and its economic fallout.
The ARPA limits how states can use the money, and details are beginning to trickle out of Washington with more expected in the coming weeks. We now know state and local governments are allowed to use the money for the following purposes:
The law contains specific language prohibiting the use of federal funds to make pension deposits or to cut taxes. The operative language restricting tax cuts is the following:
A State or territory shall not use the funds provided under this section or transferred pursuant to section 603(c)(4) to either directly or indirectly offset a reduction in the net tax revenue of such State or territory resulting from a change in law, regulation, or administrative interpretation during the covered period that reduces any tax (by providing for a reduction in a rate, a rebate, or a deduction, a credit or otherwise) or delays the imposition of any tax or tax increase.
States eagerly await an explanation of precisely what tax changes are and are not allowed. These parameters will come in the form of comprehensive Department of the Treasury guidance. In the meantime, the Treasury statement from April 7 seems to open the door to some tax conformity changes that would be permissible under the ARPA. States could then pursue pro-growth tax changes that involve conforming to and decoupling from the federal government’s Internal Revenue Code (IRC).
In the meantime, however, Treasury has decided to address a question that has arisen frequently: whether income tax changes that simply conform a State or territory’s tax law with recent changes in federal income tax law are subject to the offset provision of section 602(c)(2)(A) of the Social Security Act, as added by the American Rescue Plan Act of 2021. Regardless of the particular method of conformity and the effect on net tax revenue, Treasury views such changes as permissible under the offset provision.
The National Law Review (NLR) was one of the groups asking Treasury for clarification about whether conformity changes would trigger the ARPA’s claw-back provision. While Tax Foundation has pointed out that Treasury’s clarification still leaves much to be explained, NLR has taken a broad interpretation of the statement of the tax changes that will be allowed by Treasury. NLR writes:
This is a step in the right direction and should ease concerns of state legislatures. Passing a conformity bill will not cause any loss of federal funding. Treasury’s guidance, because it applies to all “methods of conformity,” should cover any legislation that either couples with or decouples from the Internal Revenue Code.
If states are allowed to deploy funds as a part of conforming to or decoupling from the Internal Revenue Code, they have some tools to enact consequential pro-growth state tax changes. Such conformity changes are commonplace and occur when a state adopts a provision from the federal IRC for the state tax code, or when it decouples the state tax code from a section of the IRC. Below are income tax conformity changes that states can presumably make which would add or subtract IRC provisions from state tax codes in a way that would make the state more attractive for investment and job creation.
Perhaps the most pro-growth change enacted in the 2017 Tax Cuts and Jobs Act (TCJA) was 100% bonus depreciation for business investments in machinery and equipment, also known as full expensing. This relieved manufacturers and other businesses of the so-called “factory tax.”
Business income is defined as revenue minus costs, and that differential makes up the income tax base. Costs include things like payroll, insurance, and investments. The IRC imposes amortization schedules to depreciate investment costs over time instead of allowing the costs to be deducted all at once. This creates a bias against these types of investments because amortization prevents businesses from fully deducting the cost of their capital investments. Thus, companies pay higher taxes on their investments, and sometimes pay taxes on income that doesn’t exist, resulting in less investment and growth. The TCJA corrected this problem for short-lived assets by providing 100% bonus depreciation for investments in machinery and equipment, covered in IRC Section 168(k) and Section 179. However, the IRC’s 100% bonus depreciation begins to phase out in 2023.
States should decouple from the phase-out provisions in IRC’s Section 168(k) and make Section 168(k) and Section 179 permanent features of their tax codes. This change improves the state’s tax code by removing a bias against investment, and it helps states achieve stronger growth in capital-intensive industries like manufacturing.
Current federal law allows businesses to deduct research and development costs in the year they are incurred, as the US has done since 1954. However, the TCJA contained some tax increases to raise revenues, and one such change is the upcoming amortization of research and development costs. Business research and development (R&D) costs are a key ingredient in an innovation economy, and current federal law schedules these costs to be amortized beginning in 2022. Most states automatically conform with this provision from IRC Section 174 and adopt the amortization of R&D expenses.
States should decouple from the federal law’s pending amortization of R&D expenditures and make R&D costs permanently deductible in the year they are incurred.
The TCJA also made changes to business net operating losses (NOLs) that restricted business ability to achieve rapid tax rebates when they experience income losses. The changes included the following:
However, in response to the pandemic, the federal CARES Act provided more generous treatment of NOLs by allowing five-year carrybacks for losses sustained in 2018, 2019, and 2020. This provision allows businesses to deduct losses sustained in 2018-2020 against income earned in the five preceding years to achieve a more rapid tax refund. The purpose of this change was to quickly provide liquidity to businesses that were struggling to stay afloat and make payroll during the pandemic.
States can adopt this short-term improvement to NOL treatment from the CARES Act, and then go further by permanently improving their treatment of NOLs as described below.
Very few states conform with the federal treatment of NOLs, which is covered in IRC Section 172. However, they can adopt the federal treatment of pandemic losses in the CARES Act, as described above. They should also conform with the IRC’s unlimited carryforward provision for net operating losses, although such conformity should not include the federal code’s limitation on operating loss deductions to 80% of annual business income. In addition, states should create operating loss carryback provisions of perhaps two years as a part of the same conformity bill.
Another change to the federal tax code that will increase revenues in most states is a limitation on business deductions for interest costs. This provision, covered in IRC Section 163(J), was paired with full expensing in 168(K) to reduce the tax code’s bias for debt-financed investments over equity-financed investments. States have broad conformity to the federal treatment of business interest expenses.
States can remain conformed to the 163(J) limitation on business interest costs, which will produce additional revenues in upcoming years, and then use the resulting revenue to reduce the overall business tax rate in a manner that is revenue neutral. Alternatively, states can decouple with 163(J).
Further Treasury guidance will help settle what is and is not allowed within state tax changes, and many of the issues involved will ultimately be litigated by states. However, if Treasury is opening the door for states to deploy excess federal aid dollars to make tax conformity changes, states should seize the opportunity to right-size their business tax codes to drive more investment and job growth in their states. If states are able to use federal funds to make pro-growth conformity tax changes and, in addition, replenish their unemployment insurance trust funds, that will go a long way towards using the funds for sustainable pro-growth purposes.