State Responses to the TRA86 Revenue Windfalls: A New Test of the Flypaper Effect

Abstract

In our U.S. federal system, the income tax structures used by the three levels of government are interrelated in complicated ways. Many states link various components of their income tax codes to the federal income tax code; state and local income taxes are deductible at the federal level; and several states permit federal income taxes to be deducted at the state level. Consequently, changes in the federal tax system, such as those embodied in the Tax Reform Act of 1986 (TRA86), are likely to have significant ramifications for lower levels of government. In some cases, policymakers may propose federal tax reforms specifically to change state and local behavior. For example, the proposal to eliminate the federal deductibility of state and local taxes was justified in part as a way to put downward pressure on state and local spending. However, many of the consequences of federal tax reform for subnational governments are probably more appropriately viewed as unintended, although sometimes predictable, by-products of the federal action. This paper focuses on one set of the potential unintended effects of TRA86 on state governments, namely, those associated with the so-called windfall gains (or, in some cases, losses) that occurred because many state tax structures are linked by definition to various components of the federal tax code. TRA86 both broadened the base of the federal personal income tax and lowered marginal tax rates. Base broadening by itself would have raised federal income taxes; the combined effect of base broadening and rate reduction was to reduce federal personal income taxes by about 10 percent.' This broadening of the base of the federal personal income tax automatically increased state tax revenues in any state that tied its tax base to the federal base. As discussed further below, the magnitude of these windfall gains (or losses) varied across states according to the mechanisms through which the state code is linked to the federal code; in many states, such windfalls accounted for a significant portion of state income tax revenues.