State budget deficits likely to spur major tax changes

Peter Michalowski
State and Local Tax (SALT) Leader, PwC US

State budget deficits likely to spur major tax changes

State and local finances have been strained by COVID-19, and while the full impact of the pandemic is not yet known, it is likely to be significant. For example, the Congressional Research Service cites an estimate for the overall state budget impact of COVID-19 through the 2021 fiscal year of between $158 billion and $203 billion, depending on the speed of the economic recovery. So far the states’ responses have been limited, but recent actions and proposals signal possible state approaches to filling these expected budget gaps.

Significant impact on state and local revenue

COVID-19 generally has impacted all the major state and local revenue streams, including personal and corporate income, sales and use, excise, employment, and property taxes. The most immediate and most material decline has been in income taxes, with many states following the federal government in delaying the April 15 filing and payment deadlines to July 15. This had the effect of pushing substantial amounts of payments into the 2021 fiscal year, which in most states begins on July 1. 

However, May revenues showed the significant reach of the downturn into all tax types. In many cases, these revenues were reported in filings for the previous month of business activity, reflecting the first full month of COVID-19 impact. In New York, state tax receipts were down by $767 million, or almost 20%, compared to May 2019. Local sales tax collections were down 32% for the month.

The long-term fiscal impact remains uncertain and depends on the shape and speed of the economic recovery. Further, whether there is a “Phase IV” relief package with significant state and local government relief beyond that provided under the CARES Act will also shape future state responses to this downturn.

States and localities crafting a variety of responses

In the near term, states and localities have focused on alleviating the impact of the downturn to the extent possible. Our tracking shows that in many cases states have delayed tax payments despite the compounding impact such relief has on revenue flows. States closed the 2020 fiscal year despite these shortfalls with a variety of accounting maneuvers, use of rainy day funds, borrowing, federal aid, and budget cuts. 

States are now beginning to wrestle with how to meet the looming shortfalls for the 2021 fiscal year. For those states that have acted, the full story is yet to be written. For example, New York enacted its budget with limited revenue raisers, including decoupling from certain provisions of the federal CARES Act. However, multiple other proposals are pending in the state’s legislature given the size of the budget deficit and threatened spending cuts, including variations on Maryland’s novel tax on digital advertising.

California’s budget package signed by Governor Newsom on June 30 includes echoes of its response to the last recession, such as limiting tax attributes that would otherwise offset income of profitable companies. The budget agreement includes a suspension of net operating losses for 2020 through 2022 for companies with over $1 million of net business income and a cap on business tax credits of $5 million for the same years. While these measures are slated to increase revenues by over $9 billion over the three-year period, further revenue enhancers will likely be considered, including a potential corporate tax rate increase.

The California and New York budgets are two examples of policies likely to be considered by other states. In California’s case, the state looked to larger businesses with positive net income in the near future by limiting the use of loss deductions and credits. New York -- a state with “rolling conformity” to the IRC -- limited the negative fiscal impact of certain CARES Act stimulus measures, as some other states have also done.

Proposals provide a hint of what actions may come

Raising both individual and corporate tax rates for the highest tier is a likely avenue to be considered by the states. What remains to be seen is whether proposals targeted at sectors seen as profiting during COVID-19, such as “excess profits taxes,” gain traction. New York Assembly Bill 10357, sponsored by Assistant Speaker Ortiz, for example, provides: “All businesses with profits over $500,000...that  during  the state disaster emergency...have seen an increase in profits by 20% over the same time period in 2019 shall deposit  5%  of  such  business’ gross profits into the COVID-19 essential workers appreciation fund[.]” Similar sentiments could extend to highly compensated executives, including such proposals as “CEO pay ratio” taxes.

There may also be an interest in reversing certain actions taken before the pandemic when state rainy day funds were at their best condition since the last recession. These include business tax rate cuts and franchise tax phase-outs. In some cases where revenue triggers were included in tax cuts and phase-outs, these measures could be stalled by operation of the law. States may also look at certain decoupling from the base broadening measures under the TCJA, such as taxing foreign income (GILTI).

One area that will merit close attention are efforts to expand the sales tax base or to impose gross receipts taxes. Both these policies provide a potential benefit to state and local governments due to their application irrespective of profitability. However, the implications to businesses and consumers will make adopting these policies difficult, especially during a downturn. One way states have imposed gross receipts taxes in the past during recessions is to couch them as “alternative minimum taxes” and to exempt smaller businesses. Another possibility is states expanding the sales tax base by eliminating exemptions, especially for business-to-business transactions seen as costly “tax expenditures.”

Finally, as my colleague George Famalett noted, enforcement is likely to follow leniency as states and localities look to make up lost revenue and auditors return to work. Amnesties also are a common method of raising revenue to close budget gaps. Sometimes these amnesties are paired with increased penalties for nonparticipants, providing auditors with more leverage as they seek nonfilers and assert underpayments.

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