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It is unlikely state and local governments have experienced a year like 2018 in a long time. Revenues continued to rebound from the pre-recession lows of 2008-09. The U.S. Supreme Court decision in the Wayfair case promises to bring in billions of dollars in new sales tax revenue from online retailers and other remote sellers. However, the federal Tax Cuts and Jobs Act (TCJA or the Act) created considerable uncertainty for states. It required action by many to avoid the income and franchise tax revenue losses associated with expanded bonus depreciation and section 179 that took effect for assets placed in service in September 2017. The main impact of the TCJA will be felt in the 2018 tax year. States are sifting through a mix of tax reductions, e.g., 20 percent deduction for pass-through entity income, and tax increases, e.g., business interest deduction limitation, in an attempt to meet their tax policy and budgetary goals. Some states have used TCJA windfalls like the section 965 repatriation dividend provisions to fund temporary tax cuts or broader state tax “reform” packages.

From a fiscal standpoint, the picture for states improved on the revenue side, but remains somewhat cloudy overall. The Pew Charitable Trusts’ “Fiscal 50: State Trends and Analysis” reveals that 2017 tax collections, adjusted for inflation, in 34 states exceeded their collections immediately prior to the last recession. In the fourth quarter of 2017, tax collections rose to a new high, 9 percent, which is above where the 2008 collections peaked right before the recession. While part of this increase was due to economic growth, it was also driven by taxpayers accelerating income prior to the end of 2017 in anticipation of TCJA provisions like the $10,000 limitation imposed on the federal itemized deduction for state and local taxes.

Spending pressure continues to affect the areas of healthcare, public education and infrastructure investment. The Pew report reveals that between fiscal years 2002 and 2016, 11 states outspent their revenues, experiencing a cumulative deficit that will be dealt with by taxpayers in future years. The list of states in the red from highest to lowest shortfall are New Jersey, Illinois, Massachusetts, Connecticut, Hawaii, California, Kentucky, Maryland, New York, New Mexico and Michigan. This fiscal straightjacket is being tightened by large unfunded retiree pension and retiree health insurance obligations.

Election-year politics are also creating uncertainty for policymakers as they face public ballots or legislative measures restricting their ability to raise taxes. Gov. Rick Scott of Florida proposed a constitutional amendment that will require a supermajority (two-thirds) vote of the state legislature to increase any state taxes or fees. Proposition 126 on the ballot in Arizona prohibits the state, county, municipal and other local units of government from levying any new or increased taxes on services after Dec. 31, 2017. North Carolina is mulling a proposal to cut the constitutional cap on the top personal income tax rate to 7 percent from 10 percent.

Federal fiscal policies represent a final “joker in the deck” for state and local governments. Economists have forecast record budget deficits resulting from the passage of the TCJA. In spite of this, Congress and the president have shown some interest in passing Tax Reform 2.0. This will inevitably exert downward pressure on federal spending and cuts in areas that states and localities rely on to fund their own programs. Another major tax bill will aggravate the state-local tax and economic policy confusion that now prevails in the wake of the TCJA. An example can be seen in the actions of states like California, Connecticut and New York, which have enacted “workarounds” to give residents federal tax relief from the $10,000 state and local tax deduction cap.

View more insights in the 2018 year-end tax planning letter >

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The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.

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2018 Year-end tax letter | International taxation