Tax Break in Federal Recovery Bill Will Reduce Pa. Revenues Unless State Acts

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Policymakers can avert revenue loss that would worsen state budget crisis

HARRISBURG, PA (May 22, 2009) — An obscure business tax break in the federal economic recovery package could cost Pennsylvania and most other states billions of dollars over the next few years, but lawmakers can take simple steps to prevent the loss, according to a report from the Washington, D.C.-based Center on Budget and Policy Priorities.

Since Pennsylvania’s corporate tax code is based on federal law, the cut in federal taxes will reduce state revenues as well as federal revenues. While it is impossible to predict any state’s actual revenue loss, the report’s author estimates that Pennsylvania could lose approximately $246 million in revenue in fiscal years 2009-2011.

“In these tough times, Pennsylvania policymakers need to think about priorities,” said Sharon Ward, director of the Pennsylvania Budget and Policy Center in Harrisburg. “What’s more important? Education, health care, and public safety, or increasing profits for out-of-state corporations?”

Obscure Federal Tax Provision Could Cost Pennsylvania Millions

The federal tax provision in question is generally referred to as the “cancellation of debt income” (CODI) provision. When a business is able to repurchase its debt on the open market at a discount, it must count the amount of that discount as taxable CODI. The CODI provision allows businesses that buy back their debt at a discount to wait four years before beginning to pay taxes on the income the discount represents.

Because Pennsylvania’s corporate tax code is based on federal law, the provision will reduce state revenues. The state stands to lose $246 million in revenue in fiscal years 2009, 2010, and 2011 because of the CODI provision, according to Michael Mazerov, author of the Center’s report.

The Pennsylvania estimates in the report assumed both corporate and non-corporate entities would be able to reduce Pennsylvania taxes from the CODI provision. Further analysis concludes that only corporate taxes would be affected. Based no that, the estimated losses from the provision are $49 million in FY 2009, $128 million FY 2010, and $69 million in FY 2011.

Revenue losses will be concentrated in the 2009-2010 fiscal year — which in Pennsylvania begins on July 1, 2009 — and the year after that. However, Pennsylvania could feel the impact as early as the current quarter because the provision was retroactive to the beginning of 2009, and because businesses have to pay estimated taxes each calendar quarter.

Policymakers Can Prevent Further Revenue Loss by “Decoupling” from Provision

Pennsylvania can easily avoid this significant revenue loss if lawmakers amend state tax laws to “decouple” their definition of gross income from the new CODI provision. 

Already, other states are beginning to decouple from this provision. Florida, Maryland and Minnesota have enacted legislation to decouple, and other states are considering doing the same. All other states except Nevada, Texas, Washington, and Wyoming could be adversely affected if they fail to decouple.

“States that fail to decouple will needlessly compound their already serious revenue losses caused by the recession,” said Mazerov, who is a senior fellow at the Center on Budget and Policy Priorities. “This will lead to deeper spending cuts and tax increases, which will further harm state economies and worsen job losses.” 

Breaking the link between a state’s tax code and a federal provision is not unusual. In recent years, more than 30 states have taken similar action to avoid a revenue loss arising from the “bonus depreciation” tax provision of previous federal recovery bills.

Pennsylvania Revenues Already Hard Hit by Recession

State revenue loss resulting from the CODI provision would come at the worst possible time. Governor Ed Rendell has proposed nearly $1 billion in state funding cuts to hundreds of line items in the 2009-10 budget, including agricultural programs, arts and economic development. Senate Republicans have proposed deeper cuts, impacting every state department and agency, and reducing funding for education, health care and public safety, among many other areas.

Revenue is down nearly 8% compared to this time last year as income and sales tax collections have been hard hit by rising unemployment and falling consumer spending. Pennsylvania’s budget problems are expected to continue into 2011.

The Center on Budget and Policy Priorities’ report, “Obscure Tax Provision of Federal Recovery Package Could Widen State Budget Gaps” is available here.