Lending a helping hand: two governments can work together.

To illustrate how this agreed-upon starting point simplifies tax compliance and administration, consider a simple matter such as wages, reported on W-2 forms to millions of workers every year. Wages include cash payments but exclude an array of employer-provided benefits such as health and life insurance, working condition fringe benefits, educational benefits, and employers' contributions to the various payroll and unemployment taxes. In fact, dozens of codes on the back of recent W-2s explain exactly what is included or excluded from the line "wages."

States that adopt the federal wage definition greatly simplify taxpayer compliance efforts since preparers of W-2 forms only need to calculate wages under one definition. If states independently determine what constitutes "wages," each of the millions of employers has to be familiar with and account for state differences for each state in which the employer has employees. Federal and state differences also introduce the possibility of inadvertent errors on the part of taxpayers who must first become aware of the differences and then keep track of year to year changes across perhaps many states. Administration is simplified since state auditors can use the results of a federal adjustment to the wages line without performing their own calculations of the amount of under/overstatement. With a uniform wage definition, the state adjustment will be the same as the federal adjustment.

The presumption is that coordination of the federal and state taxable base minimizes compliance and administration costs. Studies of individual income tax and business income tax compliance costs have been done, (9) but none attempts to estimate the cost savings of federal and state coordination. Prior research, however, finds that disconformity between states increases state tax compliance burdens and that greater uniformity could generate substantial compliance cost savings (Gupta and Mills, 2003; Hildreth et al., 2005).

Policy Challenges of Conformity

The states' dependence on the federal base introduces tension between levels of government, particularly when changes in the federal tax law occur. Tax policy decisions at the federal level most often ignore potential impacts on state revenues. (10) States have the option of accepting the federal changes and the impact on their own budgets or decoupling from the federal provision and, therefore, increasing complexity. For example, the federal response to the recession in the early 2000s was to reduce tax on many business activities and provide major investment incentives, largely funded with a federal budget deficit. Because states require a balanced budget, and the federal changes were estimated to cost states as much as $14.7 billion over three years (Dennen, Nakamura, Hogroian, and Weinreb, 2002), many states chose to decouple from the most generous federal changes, such as bonus depreciation and IRC Section 179 asset expensing. Furthermore, when states need additional revenues, they may find it politically easier to decouple from selected federal provisions (rather than increasing marginal rates) without considering the increase in complexity and, therefore, increased administration and compliance costs.

The estate tax at the federal and state level is informative, both as an example of a perfectly conforming state tax and how federal action can have dramatic but perhaps unintended impacts on state revenues. Prior to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the federal estate tax allowed taxpayers a credit (subject to limits) for state death taxes paid. States had no desire to tackle difficult estate tax audits for the relatively small incremental revenue (11) and 38 states simply assessed a "pick-up" tax equal to the maximum allowed federal credit. This approach vastly simplified the estate tax compliance and administrative burdens as taxpayers essentially had a single return to complete (Form 706), which determined both the federal and state death tax owed. State auditors relied almost entirely on the federal return and audit results and were tasked only to ensure that the proper amount was actually remitted to the state. Taxpayers were indifferent to the state estate "pick-up" tax since any amount not paid to the state would reduce the federal credit allowed and increase the amount, dollar for dollar, due to the federal government. Effectively, this arrangement was equivalent to a national estate tax and a federally determined grant to the states.

This simple and effective situation changed dramatically with EGTRRA. The Act phased out the credit over time and replaced it with a simple deduction. This change literally gutted the estate tax system of the "pick-up" states because when the maximum federal credit allowed for state taxes paid went to zero, so did the state estate tax for the 38 states with a pick-up tax. Some states passed legislation establishing a new estate tax, often based on what the credit was at some point in prior law, but most have not legislated a replacement estate tax.

Furthermore, the federal change significantly increased the compliance and administration burdens for taxpayers and state governments. Since the state death tax is now in addition to the federal tax (whereas before it was an offsetting credit) taxpayers have, for the first time in many states, an incentive not to file a state return. State auditors now must first ensure that each estate properly files a return and must audit the return, at a minimum for mathematical accuracy, and to account for differences between the federal and state exemption equivalents. For taxpayers and tax professionals, the estate tax regimes that replaced the "pick-up" tax vary from state to state, with different exemption amounts and rates. In addition to filing a separate state tax return, tax and estate planning strategies that assumed a uniform state and federal death tax are no longer valid and must include provisions that allow for different strategies and post-death actions on the part of executors depending on the particular state estate tax in effect at death. Taxpayers also have, for the first time, an incentive to locate in states with lower estate taxes, or to plan their estates to take advantage of state rate differences.

The policy challenge facing federal and state governments is to allow for the desirable differences in the tax rate and tax base, but in a manner that minimizes the compliance burdens and economic distortions. The "pick-up" estate tax may have been popular because the state revenues raised by the tax were minor and legislative tinkering would unacceptably increase the compliance and administrative burden without an offsetting beneficial impact on state revenues or other policy goals. With corporate income taxes only comprising approximately ten percent of state revenues, weighing disadvantages of decoupling from federal rules with the benefits would likely reveal a greater preference for conformity than currently exists. States should reserve decoupling for the most significant items that are critical to accomplishing their economic development goals.

Active Cooperation

Federal-State Exchange of Information

Despite the many significant hurdles presented by tax-regime differences, states and the federal government have found a number of areas where cooperation is possible and increasingly efficient. The cornerstone of cooperative tax administration in the United States is an active exchange of information between federal and state tax authorities to support enforcement of the personal and corporate income tax. The recent increases in information exchange (discussed below) are likely due to several factors. First, the visibility of tax-planning abuses, particularly by large corporations, makes enforcement strategies more politically important. Second, advances in technology make information sharing easier and more cost effective. State and local revenue departments constantly face limited resources, and the political climate and competition for business has made raising tax rates or implementing new taxes more difficult. Finally, continually changing business practices have also contributed to the increase in information sharing. As businesses develop more complicated structures, tax administrators are forced to specialize in certain areas and certain industries.

Federal law authorizes the IRS to provide federal tax return information to state tax agencies, provided it is used solely for tax administration purposes and is properly safeguarded against unauthorized disclosure or release. (12) All states have entered into an exchange of information agreement with the IRS through which they routinely receive an abundance of tax information. Information exchanged includes copies of all federal audits or other adjustments to a taxpayer's return, identification of taxpayers filing a federal income tax return with an address in the receiving state, extracts of items of income and expense reported on the federal tax return, information reports filed by third-party payers (e.g., banks, brokerage firms, and employers) with respect to taxpayers in a particular state, address and location information for taxpayers, and information on possible taxpayer assets available for levy.