Alabama Should Pursue Permanent, Not Piecemeal, Solutions to Federal Deductibility Issues

Alabama lawmakers are acting to ensure that federal relief from the American Rescue Plan Act (ARPA) does not increase tax liabilities in the state. Senate Bill 152, which addresses the issue, recently passed and has been referred to the Ways and Means Committee.

This unusual issue is a consequence of Alabama offering a state-level deduction for federal taxes paid. While well-intentioned, this deduction causes some peculiar tax distortions, including raising state tax liability in times of federal assistance. It’s good that legislators are acting to protect Alabamans in this instance, but the need to act raises the question of why this problematic deduction continues to exist in the first place. Lawmakers should take the extra step of eliminating federal deductibility, paired with a revenue-neutral rate reduction, to prevent future distortion and unlegislated tax increases.

If this series of events seems familiar, that’s because something similar has, in fact, happened previously. In 2020, taxpayers in Alabama (and a handful of other states) would have automatically seen increased state tax liability through CARES Act rebate payments, but the legislature acted in time to prevent it.

When Alabamans calculate their state taxable income, they subtract the amount they owe in federal taxes. The intent of this policy is undoubtedly pro-taxpayer, but it ties states’ tax codes to federal policy in unexpected and often undesirable ways. It turns the state code into an inverse mirror of the federal code: when federal taxes go down, state taxes go up. When the federal government provides preferential treatment of something—from the Child Tax Credit to ARPA relief to research incentives—states with federal deductibility penalize it.

This state-level deduction for federal taxes paid exists only in five states. Fortunately, two states are on track to eliminate the policy in the next few years. Alabama should join them.

Alabama is now the only state that retains unfettered federal deductibility for both individual and corporate income taxes. Iowa offers the same, but now only for its individual income tax (where it is also on track for elimination), while Missouri, Montana, and Oregon provide the deduction for individuals and cap the benefit. Additionally, Missouri and Oregon phase out the deduction entirely for high earners.

Iowa has already repealed federal deductibility for its corporate income tax, resulting in significant rate reductions, and will do the same for its individual income tax in 2023. Louisiana, previously the only other state to provide an uncapped deduction for both individual and corporate taxes, repealed all deductibility as of January 1, 2022 and implemented significant offsetting rate reductions. A tax simplification package adopted in Montana in 2021 will repeal federal deductibility as of 2024.

Alabama’s averted tax hits from the COVID-19 relief checks (“economic impact payments”) in 2020 and the current effort to do the same with enhanced Child Tax Credits and other ARPA aid are especially salient examples of a phenomenon that happens every day in federal deductibility states. Beyond pandemic relief, the deduction increases state tax liability when small businesses invest, when families have children or adopt, or when people give to charity. 

Simply repealing federal deductibility is, unequivocally, a tax increase. Instead of using repeal as a revenue-raiser, Alabama policymakers should look to replace this well-intended but ineffectual policy with something better, and easier to understand: lower tax rates.

Imagine a single taxpayer with $50,000 in taxable income (pre-federal deduction) and federal income tax liability of $6,748. In a state without federal deductibility, a 5 percent flat-rate tax would generate $2,500 from them. With federal deductibility, however, the rate would have to be 5.78 percent to raise the same amount from this filer. Taxpayers would be better off with the lower rate, which is neutral in its application, compared to the distorted incentives of federal deductibility.

Alabama is the only state where a constitutional amendment would be necessary to repeal federal deductibility, so lawmakers cannot lift the impediment immediately. But as they combat some specific effects of federal deductibility, they should begin the process of getting rid of the deduction altogether in favor of a commensurate across-the-board rate cut. In this way, policymakers can take the pro-taxpayer intentions behind the ill-considered deduction and turn them into reality.