Congress’s deal to avoid falling over the so-called “fiscal cliff” has dominated headlines since New Year’s Day. That “cliff” was automatic spending cuts that would kick in at the beginning of the year coupled with a number of tax rates (a.k.a. the “Bush tax cuts”) that would expire.
As you undoubtedly know, the deal that was reached raised taxes, but did not decrease spending.
Newspapers have been full of stories about the federal income tax increase on taxpayers earning $400,000 or more ($450,000 for families), bringing the top federal income tax rate up to 39.6 percent from 35 percent. But far from being a tax hike only on the rich, many businesses pay their taxes through the personal income tax code. According to data from the U.S. Treasury Department, at least 67 percent of all income generated by the most common types of small businesses falls into this tax bracket. There is no question that these higher tax rates will translate into fewer job growth opportunities in the U.S. at a time when they are badly needed.
The parts of the deal that sparked the fewest news stories, however, may be some of the most important. Take the changes to the capital gains tax. Although the rate went up to 20 percent from 15 percent for taxpayers earning above $400,000, the 15 percent rate was locked in for everyone earning below that amount. Ten years from now there won’t be any congressional kabuki theater necessary to keep that 15 percent rate. Although not a complete victory, this is a very good policy change.
But the ability of businesses to deduct a larger share of their capital investment as they can now was only extended for a year. This “bonus depreciation” allowance lets businesses to deduct from their taxes an additional 50 percent of the total value of their new equipment purchases, like copy machines and computers. Without the bonus deduction, they would be able to deduct only a much smaller amount.
The good news is that states can help counteract some of the effects of these federal actions. In Arizona, for example, the capital gains tax cuts that were signed into law by Governor Brewer will bring that effective tax rate from 4.54 to 3.4 percent over the next three years. That cut can be phased in faster to at least partly counteract the federal capital gains tax hike on job creation. And any state with an income tax could go even further by eliminating its capital gains tax entirely.
Additionally, a legislature can allow a full 100 percent deduction for equipment purchased by small businesses in their state. Not only would this make a state more competitive in attracting jobs, but it will also add an important bit of certainty to the business plans of employers who aren’t sure what the federal government will do at the end of 2013.
States don’t have to be at the whim of Congress. They can take control of much of their fiscal destiny by reforming their tax codes and showing the feds how to do it right.
Goldwater Institute: State Tax Policy and Entrepreneurial Activity