Nebraska businesses face 2023 tax increase unless Legislature acts
Nebraska lawmakers enacted tax relief in 2022 in the form of LB873, which cut individual and corporate income taxes, eliminated taxation of Social Security benefits, and expanded a property tax credit program. The lion’s share of the tax relief will go to households in the form of income tax cuts and property tax credits, yet businesses will also see tax reductions in coming years. Ironically, in the very same years as LB873’s business tax relief is phased in, other Nebraska business taxes will be increased in a way that will make Nebraska less attractive for investments in manufacturing and innovation.
Nebraska is on track to provide much-needed corporate income tax rate reductions that will lower rates from 7.5% in tax year 2022 and 7.25% in tax year 2023 down to 5.84% by tax year 2027. In dollar terms, the law provides Nebraska corporations with $5 million in new income tax relief in fiscal year 2023-2024, which will grow to $84 million by fiscal year 2027-2028, according to the fiscal note for LB873. Prior to LB873 being enacted, Nebraska’s corporate tax rate was among the highest west of the Mississippi River. Only Alaska, California, Oregon, Minnesota, and Iowa had higher tax rates, though Iowa had already enacted a law to cut its rate to 5.5%.
Here’s where it gets complicated. The business tax rate is important, but so is the tax base, meaning what the state defines as taxable income. While Nebraska business tax rate reductions will be phased in through 2027, Nebraska’s definition of taxable income will be broadened over the same time period due to changes in federal law.
Like all states that levy an income tax, Nebraska conforms to many sections of the federal Internal Revenue Code (IRC). This means that Nebraska adopts certain federal definitions, such as those that determine taxable income, in order to make a state definition for taxable income. While conforming to federal law is a good idea in general, because it provides simplicity for Nebraska taxpayers who pay both state and federal taxes, changes in federal tax laws can sometimes result in changes Nebraska lawmakers might not have intended.
The federal tax treatment of capital investments is scheduled to get much worse beginning in 2023. Nebraska lawmakers should head off this particular tax base expansion because it will automatically legislate a tax increase that is especially harmful to economic growth for each dollar of new tax revenue.
Here are the details. IRC Section 168 and IRC Section 174 cover tax depreciation rules for capital investments. These investments are considered business costs which (like labor) businesses are allowed to deduct against taxable income. In 2022, businesses can fully deduct the cost of capital investments in short-lived assets (those with a 20-year asset life or less) in the year when the property is placed in service. This policy is known as “full expensing,” and is critical for economic growth.
Beginning on January 1, 2023, however, the federal tax code will not allow full expensing for short-lived assets like machinery and equipment. Bonus depreciation will phase down from 100% through 2022, to 80% in 2023, to 60% in 2024, to 40% in 2025, to 20% in 2026. By January 1, 2027, businesses will not receive any first-year bonus deduction for their capital investments.
Though these rules are arcane, they have a meaningful impact on the incentive to invest. Removing full expensing at the state-level in Nebraska imposes a counterproductive Factory & Innovation Tax on businesses that invest in physical capital, new technology, and research and experimentation.
Imagine a business that invests $10 million in food manufacturing machinery and equipment in Nebraska. Instead of being able to immediately write off this $10 million cost, the business will have to take deductions over 20 years to write off the cost. Yet the real value of these deductions shrinks every year due to inflation. According to the Tax Foundation, assuming 5% inflation, businesses will lose half of the value of their cost recovery when they have to depreciate an asset over 20 years instead of writing it off immediately. In short, when federal full expensing goes away, Nebraska businesses will be hit with a state tax increase for capital investments made in Nebraska.
Paradoxically, while Nebraska would otherwise achieve greater economic growth by cutting its corporate income tax from 7.5% to 5.84% over coming years, it will lose this growth effect due to the loss of full expensing. That’s because each dollar of tax revenue raised when full expensing goes away costs Nebraska roughly twice as much in economic growth as each dollar forgone as a result of cutting the corporate rate. In a sense, Nebraska will be taking one step forward and two steps back when these business tax changes phase in simultaneously.
Although the bill did not become part of the final tax package in 2022, Sen. Brett Lindstrom did introduce by LB827 last session, which would have avoided Nebraska automatically imposing the Factory & Innovation Tax. That bill offered a straightforward solution: Rather than allowing the Factory & Innovation Tax to automatically strike Nebraska businesses, full expensing would be made permanent in Nebraska by allowing businesses the option of following federal expensing provisions, or using full expensing on their state taxes.
Effectively, this decouples Nebraska from automatically following certain parts of the federal tax law, though businesses could use the less favorable federal depreciation rules if they choose. In fact, Oklahoma became the first state to make full expensing permanent (for assets covered under IRC section 168) with the passage of HB 3418, signed by Gov. Kevin Stitt on May 26. And Tennessee unanimously passed HB 2144, which made the Volunteer State the first to make full expensing permanent for investments in research and experimentation assets (covered under IRC section 174).
Nebraska should combine both Oklahoma and Tennessee’s reforms in order to protect its competitiveness in the face of federally-induced tax increases. LB827 would have accomplished both of these changes, and lawmakers should prioritize similar legislation in 2023.
Full expensing is more critical now than ever in the face of rampant inflation and the national necessity to re-shore manufacturing supply chains. The Legislature should make Nebraska the U.S.’ most friendly state for new capital investments by codifying full expensing.