What is Tax Conformity, and What Does It Mean for SC Taxpayers?
UPDATE 10/5/18: The Senate’s version of the tax conformity bill passed both houses this week and was signed by the Governor.
Lawmakers left one major question unanswered when they left Columbia earlier this year: How will the South Carolinian’s state income tax be calculated next year? The General Assembly will address this when they come back next week. Here’s what you need to know.
What is tax conformity?
In South Carolina, state taxable income mirrors the federal taxable income (for the most part). However, this doesn’t happen automatically. Every year, lawmakers pass legislation officially adopting the federal tax code in order to ensure that the federal adjusted gross income and the state adjusted gross income are identical (except for certain provisions the state tax code opts out of).
Normally, this legislation is passed with little scrutiny. This year, however, the federal Tax Cuts and Jobs Act (TCJA) significantly altered the tax landscape.
In a nutshell, the TCJA lowered tax rates and capped/eliminated exemptions and deductions for both individuals and businesses. Conforming the state taxable income to the federal taxable income does not adjust South Carolina rates to mirror the lower federal rates: it only incorporates the new federal exemptions and deductions. This would result in higher state taxes (not higher federal taxes) for both individuals and businesses.
The director of the SC Department of Revenue testified to lawmakers earlier this year that the state needs to conform to the updated IRS code. He argued that without conforming, filing income taxes may become too complex for South Carolina taxpayers to understand, and they may simply decide not to pay their taxes at all.
However, there is no actual requirement forcing lawmakers to update the tax code, and doing so in the way they currently propose will almost certainly result in some taxpayers paying more in personal and business income taxes.
Tax conformity options: What’s on the table?
The General Assembly has four options. Here is how each option would affect taxpayers.
Option 1: Conform to the federal deductions/exemptions AND the tax cuts
Unfortunately, this is the only option lawmakers are refusing to discuss. When legislators use the term “conformity”, they are not referring to the federal rate cuts, but merely to the deductions and exemptions. Therein lies the myth of revenue neutrality: Unless taxes are cut across the board, someone’s taxes will go up – regardless of how lawmakers reshuffle the tax code. Moreover, revenue projections are just that – projections, and government may well end up collecting more revenue in the end.
Focusing on the exemptions and deductions allows the General Assembly to protect some individuals and businesses from tax increases at the expense of others. Tax favors, exemptions, and incentives are a key feature of South Carolina’s tax system, to the point that in some cases, more taxes are exempted than collected. This results in an unavoidably high tax rate for those who do pay taxes in order to ensure “revenue neutrality.”
Cutting tax rates across the board is one of the only two ways to ensure South Carolinians’ state income taxes do not increase. The other way is to leave the tax code alone.
Option 2: Leave the state tax code alone
If lawmakers refuse to cut taxes, they should do nothing to the tax code. Under this option, everyone’s state income taxes would remain the same. Federal income taxes would be based on this year’s IRS code (which includes the TCJA’s lower rates, amended/eliminated exemptions and deductions, etc.) and state income taxes would be calculated in the exact same way they were last year.
The DOR’s “concern” that tax filing may become too complex under this system is based on the claim that income taxes would now be calculated using two separate tax codes. However, state taxpayers already operate under two tax codes. South Carolina uses the IRS code as a starting point, but adds so many tweaks and exceptions that lawmakers have essentially created a separate tax code anyway.
Leaving the state tax code alone would ensure that no one’s state income taxes would increase, with no impact on federal tax returns. The DOR would prepare the state income tax filing forms and instructions as they do every year, and as state taxable income would calculated in the exact same way it was last year, it is highly unlikely that the DOR would find this an impossibly complex task.
Option 3: Adopt the federal exemptions/deductions without the tax cuts
Lawmakers could decide to simply adopt the new IRS tax code without making any additional changes. This means that South Carolina’s income tax code would eliminate or cap a number of exemptions and deductions without the corresponding rate cut provided at the federal level – resulting in higher taxes for some South Carolinians.
The Revenue and Fiscal Affairs Office (RFA) projects this impact will be highest for the state’s largest income group – taxpayers with federal Adjusted Gross Income of $50,000-$75,000, and estimates that the net corporate and individual income tax increases would net an estimated government windfall of $204 million. In other words, both individuals and businesses would see significant tax increases.
Option 4: Conformity with tweaks – picking winners and losers
This is the only option lawmakers are seriously discussing. Both the House and the Senate have filed bills that would adopt some (not all) of the amended exemptions and deductions in the TCJA, but none of the rate reductions.
For individuals, the House bill adopts the federal exemptions and deductions with the following key changes for state income tax purposes:
- Since the TCJA dropped the personal exemption ($4,050 for tax year 2016), this bill adds a state personal exemption of $1,525.
- The state’s deduction for dependents under the age of six (equal to the federal personal exemption) would be cut.
Under the Senate bill, there would be no personal exemption, but families with small children would be eligible for two separate dependent deductions. Both bills conform to the cap on the home mortgage interest deduction.
For businesses, both bills opt out of several elements of the TCJA:
- Interest expense cap – the TCJA capped the net interest expense deduction. Opting out allows South Carolina businesses to deduct all of their net interest expense from their state income tax – a net positive for businesses.
- Foreign income tax provisions – opting out of these TCJA provisions would prevent South Carolina businesses from writing off any portion of their foreign income. It should also be noted that many corporations do not pay the state corporate income tax to begin with, due to tax incentive deals.
- Taxable economic development grants – The TCJA began taxing state and local economic development grants. Both bills decouple from this provision, which means the South Carolina would not tax any economic development grants awarded by a state or local government entity.
- FDIC premium deduction – the TCJA prevents large banks from writing off any percentage of their insurance premiums. The House bill opts out of this provision, which allows all banks (large and small) to deduct all their insurance premiums.
However, the bills adopt the rest of the business deductions/exemptions, including (to name just a few):
- A limit on the deduction (80% instead of 100%) for net operating losses
- A repeal of the 9% deduction for income from property manufactured, produced, grown or extracted within the United States
- A limit on the deduction for farming equipment depreciation (reduces the cost recovery period from seven to five years, but permits an accelerated depreciation rate)
- Limited the deduction for corporations receiving dividends from other corporations
The bills also opt out of qualified business income deduction – a complex, poorly constructed tax deduction for small businesses. It is a tax relief measure, although it remains unclear exactly how it will be applied and how much relief small businesses will see.
The only across-the-board relief measure is minor: a provision in the Senate bill fully adjusts income tax brackets for inflation to prevent “bracket creep” – being shifted into a higher tax bracket (with a higher tax rate) by virtue of inflation rather than income (brackets are currently adjusted at half of inflation). The RFA estimates that this will result in a $4 million cut to the General Fund in fiscal year 2019-20. To put this into perspective, this year’s budget contained a General Fund of $8.2 billion.
While the details vary, both the House and Senate bills tweak the federal and state income tax codes to ensure that some taxpayers are favored at the expense of others, while state government continues to collect the same amount of revenue – at least.
Not only do these bills fail to insulate taxpayers from tax increases – the structure of targeted tax breaks and exemptions guarantees a back-door tax hike on some South Carolinians. Lawmakers may claim that it averages out to the same level of revenue collected, but reshuffling the tax code in this way is always a camouflaged tax increase on someone.
The fact is that state lawmakers have no pressing mandate to do anything at all to the tax code, despite the dire predictions of the DOR. However, both chambers appear set on a course which will further complicate the state income tax code and raise taxes on South Carolinians.
It cannot be stated strongly enough that revenue-neutral tax bills are not cost-neutral for taxpayers. There will be individuals and businesses whose state taxes increase regardless of which bill passes. The benefit to this approach for lawmakers is that it enables them to pick the winners and losers – and may well bring in more revenue in the end despite claims of “revenue neutrality”.
The only way to prevent taxes from increasing is a broad-based tax cut. Evidently, lawmakers would rather pass a back-door tax increase than provide solid, equitable relief for all South Carolinians. As a result, high tax rates will continue to be a primary barrier to economic prosperity in South Carolina.