States weigh the cost of tax conformity

Changes to the federal tax code from the One Big Beautiful Bill Act are filtering down to the states, which may or may not align their tax codes with what’s happening in Washington.

“Much like in 2018 states now have a choice of whether they want to sign on to these changes or not,” said Tracy Gordon, VP of tax policy, co-director and Robert C. Pozen director at the Urban-Brookings Tax Policy Center.   

“About half of states have something called rolling conformity, where it just happens, others have static conformity set to a specific date and they have to take action.” 

States retain the right to “de-couple,” from federal tax law, which typically requires legislative action.

Basing state tax laws on federal tax laws are complicated by some states over using federal adjusted gross income versus others using federal taxable income as a basis for determining state tax.

Thirty-six states have created pass through entity exemptions to avoid the cap on state and local tax deductions. Eight states have no income tax.    

According to the TPC, “at the start of 2023, 18 states and the District of Columbia used a rolling basis for conforming, and 18 states used a static basis.” Thirteen states use selective conformity where they pick and choose what provisions they are conforming to. 

States also have the right to not conform but it may not be to their advantage. 

“There are advantages for states not to conform to the federal tax changes as non-conformity allows states to protect their budgets and residents from unpredictable or unfavorable federal tax policy changes,” said Lucy Dadayan, principal research associate at the Tax Policy Center, Urban Institute & Brookings Institution.

“Non-conformity gives states greater autonomy and stability in managing own state fiscal affairs.” 

Following a relentless bipartisan lobbying campaign in the House of Representatives OBBBA lifts the cap on state and local tax deductions that was championed by representatives from high tax states including New York, which is a rolling conformity state. 

According to TPC, “In states with rolling conformity, the increased SALT cap will automatically reduce state taxable income.”  
SALT caucus members also represent New Jersey and California which are both selective conformity states. 

OBBBA keeps the Pass-Through Entity Tax workarounds used by many states to negate the effects of SALT.  The new law also makes changes to standard deductions, itemization, child tax credits, and ushers in tax deductions on tips, overtime, and car loan interest. 

“OBBBA provisions are significantly impacting state budgets, with many states expected to convene special legislative sessions to address the new fiscal challenges,” said Dadayan.   

Colorado, which is rolling conformity state and is constitutionally obligated to refund state budget surpluses is already calling on legislators to deal with a $1.2 billion budget shortage. 

The shortage is being blamed on OBBBA’s cuts to the corporate tax rate, changes in the standard deductions and no-tax provision on tips and overtime.  

The elephant in the room regarding federal versus state budget machinations is what happens as Medicaid restrictions begin to take effect? 

“Conformity or nonconformity to federal tax changes plays only an indirect role in Medicaid changes,” said Dadayan.   

“New limits on provider taxes, work requirements, and federal funding cuts—are federally mandated and apply to all states, regardless of tax conformity status.” 

“States do get some say in how they run certain parts of Medicaid, but tax conformity decisions mainly affect their revenues, not the Medicaid rules or funding they receive.”