Federal Tax Conformity: 7 Facts Our Legislature Must Face

Back in February, we raised the alarm about how the big tax changes out of Washington passed in late 2017 would actually increase state taxes due to the way that South Carolina “conforms” to the federal tax code. Our economist—Dr. Rebecca Gunnlaugsson—outlined a roadmap for how to hold taxpayers harmless and move South Carolina closer to fundamental tax reform that makes our code more competitive, stable and fair. The complicated discussion in a nutshell:

• Not conforming would create massive filing complexity (and costs) for both individuals and businesses.
• Conforming—with no accompanying changes—would result in a tax increase of between $180M-$200M, according to South Carolina’s office of Revenue and Fiscal Affairs.

House leaders correctly pointed out that this “conformity” debate is inseparable from a broader understanding of our tax structure. This link was also recently highlighted in a lengthy, “whereas”-laden preamble to a conformity bill introduced in the Senate, extolling the virtues of South Carolina’s current tax system.

Could this possibly be the same tax code that both data-driven research and real-life stories from individuals and businesses have conclusively demonstrated to be unfair, unstable and uncompetitive with our Southeastern neighbors? Below, we fact check the claims in this Senate bill and outline the 7 key facts you need to know about how South Carolina does taxes:

Fact #1: The SC Tax Code is Not Simple

Federal Taxable Income (FTI) v. Adjusted Gross Income (AGI)
South Carolina is one of only six states that uses Federal Taxable Income (FTI) as its starting point in calculating state income tax. The majority of states (29 states plus D.C.) use Adjusted Gross Income (AGI).^[1] The use of FTI makes South Carolina, and these other five states, vulnerable to changes in federal tax law—both increases and decreases. Over time, every federal change to FTI (and there have been many), has been reviewed in South Carolina and either accepted or rejected. Those rejected have ended up as a long list that SC citizens have to add back in or take back out on their South Carolina tax form, creating a very lengthy and complicated method to arrive at state taxable income.

Exemptions, Exemptions, Exemptions
In addition to extensive modifications that must be made because of using FTI, South Carolina maintains 60+ special interest deductions and exemptions (and more are added every year) which further complicate the code.

Multiple Tax Brackets
South Carolina has 6 different tax brackets, ranging from 0 to 7%. While it may seem like a progressive system, the ranges are so compressed that it is exceptionally steep, rapidly rising from the lowest to highest, which kicks in at on $14,650 of income. Additionally, certain types of income are not subject to the South Carolina tax brackets and must be calculated separately, including active trade, lump sum distributions, and excess withdrawals from certain accounts.

Fact #2: SC Income Taxes Aren’t Fair

Are income taxes in South Carolina low? On average, yes. But Mr. Average does not pay taxes: real people—in an ever-shrinking base—do. South Carolina’s 60+ legislatively-created credits and deductions totaled over $890M in 2014, and they grow each year. These selective credits create disparity between taxpayers, taxing some more than others

For example, a 65-year-old couple would pay $0 income tax on $75,000 of AGI, while a single parent with 2 children would pay $3,209 and a married couple with 2 children would pay $2,440. Those with generous credits and deductions pay very little or nothing. In 2015, 42% of taxpayer returns paid no income tax, while 41% were in the highest 7% tax bracket.

So when you combine those two facts, on average, South Carolina has a very low tax. But this comes at the price of a huge fairness gap between different types of taxpayers.

Fact #3: The SC Income Tax Structure is Not Competitive

In 2015, 41% of taxpayers were subject to our state’s top marginal individual income tax rate of 7%, the highest rate in the Southeast. All the special interest deductions and exemptions which create disparate income tax burdens, leaving some taxpayers paying significantly more than others, cannot erase the headline top rate of 7%:

• South Carolina – 7%
• Georgia – 6%
• Kentucky – 6%
• Virginia – 5.75%
• North Carolina – 5.49%
• Alabama – 5%
• Mississippi – 5%
• Florida – 0%
• Tennessee – 0% (3% income tax on interest and dividend income only)

 Fact #4: State and Local Taxes in SC are Not Low

The Senate bill preamble refers to taxes being “ninth lowest in the nation.” Perhaps this refers to the total taxes (sales, property, income, excise, corporate, etc…) paid as a percent of income, from this recent USA Today article. A few key clarifications are in order:

• South Carolina doesn’t have local income taxes, so it is not applicable to even compare our rank on that.
• The correct rank for “per capita state individual income tax collections” is 19^th lowest (or 32^nd highest) at $780 per person in 2016, which is 27% below the national average. This does not account however for cost-of-living adjustments. South Carolina has the 7^th lowest income per-capita in the nation, so the 19^th lowest income tax collections represent a comparatively larger burden on taxpayers.
• While North Carolina and Georgia do have higher income tax collections per capita, other taxes show different outcomes. For example, in the property tax category, South Carolina is 31^st highest, North Carolina is 41^st and Georgia is 32^nd.

Rankings are great headline grabbers, but the devil is always in the underlying methodology. National ratings rarely pick up the many nuances and complexities that more local experts can account for.

Fact #5: Coupling SC’s Tax Code to FTI is Not Wise Fiscal Policy

As we already noted in Fact #1, coupling South Carolina’s tax code to FTI (Federal Taxable Income) instead of AGI (Adjusted Gross Income) has resulted in an extensive and lengthy set of ad hoc changes to “back out” federal provisions that the state does not want to accept or add in other provisions that we like. Ironically, as this bill lauds the virtues of FTI, it actually backs out 3 more items from FTI, further increasing South Carolina’s tax complexity!

Which actually makes our second point for us: the idea that $37B of federal deductions would not be in place without coupling to FTI is ludicrous. South Carolina is perfectly capable of deciding for itself what deductions to give Palmetto state taxpayers.

Thirdly, the types of taxpayers listed most certainly receive generous breaks under our current tax code. But what about the people paying full freight, so that others can have their exemptions: taxpayers with children 6 and older; married small business owners with children who do not make more than $65,000, regular employees, single people…and the list goes on.

Bottom line: tying South Carolina’s income tax structure to AGI would dramatically simplify the state code, prevent us from continually being subject to the changes made at the federal level, and allow South Carolina to decide what is important to its own people itself. 

Fact #6: SC’s Tax Brackets Should Be Adjusted Now

The Senate bill has it right here. Since 1993, South Carolina’s tax brackets have increased at only half of inflation, causing taxpayers to get shifted into higher tax brackets more quickly, a phenomenon economists call “bracket creep.” Adjusting the brackets for full inflation is long overdue.

Fact #7: SC Needs Fundamental Tax Reform

The House’s conformity solution (H.5341) has already passed the full House and is now sitting in Senate Finance. Senator Hugh Leatherman’s response (S.1258) has passed neither chamber and has also been assigned to Senate Finance. Although taking slightly different approaches, both bills appear to South Carolina protect taxpayers from a conformity tax hike while minimizing additional tax preparation complexity. It is critical that the General Assembly get this issue resolved.

And no matter how much lipstick we try to put on the pig, the conformity discussion only continues to highlight our basic point: South Carolina’s tax system is unfair, complicated and uncompetitive. Fundamental tax reform is the most important priority for putting South Carolina on a strong economic footing for the future. Learn more about our specific reform recommendations here.

[1] “Tax Reform Moves to the States: State Revenue Implications and Reform Opportunities Following Federal Tax Reform.” The Tax Foundation. Special Report No. 242, January 2018.