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Calling It What It Is: A $450 Million Windfall Tax Hike!

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Virginia state government ended Fiscal Year 2019 awash in cash largely for one reason: A $466 million tax increase that fell on about 30 percent of individual taxpayers, caused by conforming to the new federal tax law without any corresponding tax reform.

That represents almost 60 percent of the $797 million end-of-year cash balance announced by Governor Ralph Northam on August 20. The $466 million in higher individual taxes was offset by an $11 million reduction in business income taxes as a result of the federal Tax Cuts and Jobs Act, leaving a net tax hike of $455 million. The 2019 General Assembly took steps to blunt the 2018 tax hike on business, but not on individuals.

The tax conformity windfall amount was calculated by outside consultant Ernst & Young LLP, Secretary of Finance Aubrey Layne told a meeting of the combined legislative money committees Tuesday. That is not the same firm hired last year to project the state tax impact of the federal TCJA. Layne said he wanted an independent look at the results.
The E&Y report is the final 23 pages of Layne’s slide presentation to the committees, here.

The first company, Chainbridge Software, LLC, estimated (here) the first-year tax hike from Virginia adopting the new federal rules – with no policy changes to compensate – would be $594 million, 28 percent higher than E&Y found. The 2019 General Assembly made no tax policy changes for individual taxpayers for 2018 and during the session Layne continued to express confidence in those estimates.

The smaller result measured by Ernst & Young is based on an actual comparison of 2017 and 2018 tax returns, with an effort to tease out the higher revenue due to the tax changes from the higher revenue due to income growth or asset sales. It only looked at returns filed by July 1, so individual and business returns delayed or extended for later filing are not included. Any windfall taxes paid by them will show up in fiscal year 2020.

The report indicates individuals overall paid $466 million more, which was reduced by an $11 million drop in corporate income tax revenue. But E&Y had only 155 tax returns from corporate income tax entities to analyze, compared to 1,284 returns from 2017. That indicates how many corporations take advantage of the opportunity to extend filing. Individual taxpayers who extend also tend to be higher income.

The gap between Chainbridge and E&Y might shrink with full data. The 200,000 late individual returns and 1,100 late corporate returns need to be wrapped in to draw firm conclusions, and those conclusions will matter because this windfall is not just a one-time thing. The General Assembly has promised to track and segregate the on-going higher taxes caused by conformity into future years in a Taxpayer Relief Fund and use it for future tax reform efforts.

As predicted by Chainbridge, the additional state revenue mainly resulted from almost 800,000 tax returns switching to the standard deduction at the federal level, and thus making the same switch at the state level. Far more people made that change than predicted by Chainbridge, Layne reported. While the federal standard deduction rose, the state’s stayed the same, resulting in higher tax.

The net effect of all those decisions to switch was an additional $7.5 billion subjected to state tax (E&Y Table 7). That accounted for almost $400 million of the tax hike revenue. The rest came from other tax changes people couldn’t avoid, including limits on business loss deductions and a change in the inflation index being used. Another change with a big impact was the new $10,000 deduction cap on state and local taxes for those who continued to itemize.
The General Assembly did make tax policy changes for individuals for tax year 2019, now underway. It increased the standard deduction starting this year, from $6,000 to $9,000 for a couple. For 2019, unlike in 2018, if you do take the itemized deductions at the state level you are not limited by the $10,000 deduction cap on state and local taxes. Those two steps will give back much, but not all, of the ongoing windfall revenue.
The General Assembly also restored a wealth tax provision for 2019, the Pease Limitation, which had been a part of federal law, but which was eliminated by the TCJA. The details on how the state will impose that with the IRS no longer doing so need to be worked out. It is possible the Northam Administration will count that revenue against the TCJA windfall, reducing future relief.
For this year, an election year of course, all Virginia taxpayers get a check. Most will get $110 per individual or $220 per couple. It will deplete $431 million of the $466 million in higher individual taxes for that year. It has no relationship to the actual TCJA impact. Many taxpayers saw no change from conformity, some saw taxes go down, and most who did pay more paid far more than $220.
More than 1.9 million of the 3.4 million resident returns examined showed no tax change due to TCJA. Of the rest, 417,000 showed that their state tax was reduced and only slightly over one million paid all the higher taxes. (E&Y Table A-3) In no single income category of that group, from negative taxable income to taxable income over $1 million, does the $220 check cancel the tax increase.
E&Y found that for 3,000 returns above $1 million the tax hike averaged $12,316 and for 12,000 returns between $500,000 and $1 million it averaged $3,082. The Chainbridge report had also predicted that the impact of conformity to TCJA would fall on only a small percentage of total taxpayers, and many would see state tax reductions or no change. The General Assembly knew that.
For most Virginians the election eve check is neither refund nor rebate, but an income transfer payment from the one million or so paying the entire windfall.
The E&Y report, at least the portion released, does not include any forward-looking estimates for the out years based on this new review of the results. Chainbridge had looked out six years and estimated $4.6 billion in higher taxes over that period. Other than in the first two years, the legislative action had not counteracted most of that. The E&Y report would point to a lower estimate.
If, as expected, the 2019 taxpayer checks total $431 million, that will leave only about $25 million to be held in the Taxpayer Relief Fund established by the 2019 conformity legislation and the state budget. The state budget revenue estimates consciously excluded any conformity windfall projection for either year, but rule one in Richmond is that no General Assembly can bind the actions of the next one. The survival of the Taxpayer Relief Fund is not guaranteed.
A version of this commentary originally appeared in the August 21 edition of the online Bacon’s Rebellion.

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