New Federal Tax Provision Threatens To Reduce DC Tax Revenues By $74 Million: the District Should Take Steps to Avoid this Unintended Revenue Loss| March 28th, 2001 |
A provision of the recently enacted federal stimulus package threatens to reduce revenue significantly in the District of Columbia over the next three years, unless DC takes steps to eliminate its impact on city revenues. The new federal law includes an enhanced tax deduction, known as "bonus depreciation," for businesses that make investments in equipment before September 2004. Because the District, like other states, ties its corporate and personal income taxes to the federal tax rules, the increased federal deduction will reduce the DC income taxes businesses pay as well.
The resulting revenue loss will be felt immediately because the bonus is retroactive to September 2001. Businesses can claim the deduction in the 2001 tax returns they are now preparing and in their estimated tax payments in 2002. The District projects revenue losses of $27 million in FY 2002 and $74 million between FY 2002 and FY 2004.
This revenue loss is not likely to be accompanied by any benefit in terms of economic stimulus to states. Incorporating the bonus depreciation provision in state business income taxes is unlikely to stimulate their economies significantly. The Congressional Budget Office (CBO) has described the federal provision’s ability to stimulate the economy as weak. Perhaps more important to DC is the fact that a multi-state corporation that makes new investments in other states could use the bonus depreciation to reduce its DC tax liability. Thus, the loss of revenue would not necessarily be tied to new DC business investment.
Four states, including Virginia and Maryland, already are moving to avoid a loss of revenue by "decoupling" from the new federal rule and maintaining the prior depreciation rules. A number of other states, particularly those that do not automatically conform to federal tax law changes, also are likely to consider decoupling to avoid revenue losses at a time when their budgets are facing large shortfalls. In recent days, District officials have expressed an interest in decoupling from the bonus depreciation provision; however, they must act soon to avoid conforming automatically with the new federal provision.
Explanation of the Federal Provision
In March 2002, the federal Job Creation and Worker Assistance Act, commonly known as the economic stimulus bill, was signed into law. Included in this new legislation is a provision that allows businesses to claim a tax deduction for depreciation of new property at an accelerated rate. In contrast to prior federal law, the new provision allows businesses to claim an immediate tax deduction of up to 30 percent of the cost of new business equipment purchases, rather than following the standard accounting approach of gradually depreciating the full cost over several years. Because the bonus depreciation is effective retroactively to September 2001, businesses can claim this deduction in their 2001 tax returns and in their 2002 estimated tax payments. The bonus will reduce federal tax revenues on profitable businesses by $97 billion between 2002 and 2004, when it is set to expire.(1)
Impact on DC
Unless steps are taken to stop it, the federal allowance for bonus depreciation will be incorporated into DC law automatically, because the District conforms its corporate and personal income tax to the federal tax. If this occurs, the District would stand to lose $27 million in 2002 and $74 million between fiscal years 2002 and 2004.
This loss of revenue would worsen an already serious budget problem in the District. The economic downturn and other factors have contributed to a $200 million budget shortfall for FY 2003, the most serious budget condition since the mid-1990s. To address this shortfall, the mayor has proposed making substantial spending cuts, suspending planned tax relief, and using tobacco settlement funds for existing programs rather than new initiatives as intended under prior law. The loss of revenue from the bonus depreciation provision would widen the budget shortfall and thus require even more painful steps to maintain a balanced budget.
The District Can Take Action to Decouple from the Federal Provision
Although the District automatically conforms to federal law, there is no obligation to do so in every case. Through legislative action, the District has the opportunity to decouple from the federal provision on bonus depreciation. There is ample precedent of states adopting their own depreciation rules when the federal rules prove to be disadvantageous.
- In 1981, the federal government adopted the "accelerated cost recovery system". The system drastically increased depreciation allowances and about half of all states promptly decoupled in whole or in part.
- At least four legislatures -Virginia, Wisconsin, Maryland, and Indiana – have moved bills recently that will decouple their state depreciation rules from the federal rules.
- In approximately 20 states, conformity to changes in federal tax law is not automatic; rather, it must be ratified by legislative action. In several of those states, key policymakers have indicated that they will choose not to conform to the bonus depreciation provision.
- California’s corporate and personal income taxes have been decoupled from federal depreciation rules for a number of years.
To decouple from the bonus depreciation provision, DC and other states would need to modify current instructions and tax forms. The revisions would instruct businesses to add back to their state taxable income the bonus depreciation amount deducted on their federal tax return.
A DC Bonus Depreciation Rule Would Be Unlikely to Stimulate the DC Economy
For several reasons, it is unlikely that incorporating the bonus depreciation provision in the DC business tax would stimulate the District’s economy. This is true in large part because the federal provision is unlikely to provide a significant stimulus. In a January report, the Congressional Budget Office noted that a tax incentive for investment that is effective for only one year could induce firms to advance their investment plans to the present. The report noted, however, that businesses might not take such action if they knew that the tax advantage would be available to them for several years, as is the case with the new bonus depreciation provision.
Even if the federal bonus depreciation ultimately does stimulate the economy, decoupling by the District and other states will not affect the federal tax incentive that corporations can receive. In this way, decoupling would allow the District to benefit from any economic stimulus that the federal incentive produces without a loss of local revenue.
Furthermore, incorporating bonus depreciation into DC’s corporate income tax would result in DC subsidizing out-of-state investments. Multi-state corporations represent a large portion of DC’s corporate tax bases. Under standard corporate income tax rules, a corporation with a presence in the District and other states would receive a bonus depreciation deduction on its DC income tax return for any equipment purchase, whether the equipment was purchased for use in the District or elsewhere. This results in businesses receiving a DC tax break for investments made elsewhere in the nation.
In light of the District’s current fiscal problems, the District should decouple from the new federal provision on bonus depreciation. The provision, which will be in effect for the next 30 months, is unlikely to be an economic stimulus for the District, but will reduce DC’s tax revenues considerably. In recent days, District officials have expressed an interest in decoupling from the new federal bonus depreciation rule. This should occur as soon as possible to limit the District’s loss of tax revenue.
1. This total is based on estimates from the Center on Budget and Policy Priorities and official published state estimates.