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While other states are considering workarounds to the Tax Cut and Jobs Act’s (TCJA) $10,000 annual limit on the federal deduction for state and local taxes (SALT) on individual income tax returns, New York became the first state to pass actual legislation. Unlike most states, New York’s fiscal year begins early on April 1, so it was motivated to act quickly. New Jersey and Connecticut soon followed will their own legislation. This may be just the beginning of a fundamental change in the way state and local governments tax residents and businesses in the wake of the TCJA.
New York made three major changes aimed at maintaining state revenues while giving residents relief from the new federal SALT deduction cap.
Two of these changes are aimed at replacing state and local tax payments, which are subject to the TCJA deduction cap, with charitable gifts that remain fully deductible against income for federal tax purposes. The third change allows workers and their employers to convert some of the state income tax paid on earnings, which is subject the SALT cap, into employer-paid payroll taxes, which remain fully deductible by employers.
The new NY law does the following:
- It establishes a state administered charitable trust fund that can receive contributions to support health care, nutritional assistance, and other services to New Yorkers, as well as public school districts in the state. Taxpayers who contribute to the state fund, or to designated not-for-profit organizations, will receive a credit against their state income taxes equal to 85 percent of their contribution in the tax year following the contribution. And plan sponsors maintain that if contributors itemize deductions on their federal income tax return, they can fully deduct the gifts from their federal taxable income as charitable contributions.
- It authorizes local governments to create charitable gift reserve funds to support education, health care, and other charitable purposes. Those that do can offer taxpayers property tax credits of up to 95 percent of the value of their contributions to the funds.
- It gives employers the option of paying a 5 percent payroll tax on annual wages above $40,000 per employee. Firms that make this election would likely reduce wages but workers would receive a tax credit to compensate them for any decline in their take-home pay resulting from the new payroll tax.
Here is how New York legislators believe the programs would work in the case of the new charitable funds: Itemizers who make the charitable gifts could deduct the full amount of their contributions on their federal income return, as the TCJA did not place new limits on deductible charitable contributions. Because the maximum credit rate for both the state and local charitable funds is less than 100 percent, contributions into the funds would cover the loss of state income tax and local property tax revenue plus administrative expenses. Even with less than a full credit for their contributions, taxpayers would still come out ahead because of the available federal income tax deduction.
Under the payroll tax option, swapping employer payroll taxes for an equivalent employee income tax credit would also keep state revenues largely unchanged. If employee wages fell by the amount of the additional payroll tax, the tax credit would keep employee incomes after state taxes the same. But because taxable wages would decrease, they would pay less federal income and payroll tax. By limiting the program to earnings above $40,000, the program also would protect workers from losing federal refundable income tax credits, such as the Earned Income Tax Credit and the Child Tax Credit. For-profit businesses would see no increase in taxes because they can deduct payroll taxes as a business expense just as they can deduct other compensation expenses.
It is not yet clear whether government-sponsored charitable funds will pass muster with the IRS, but Treasury Department reaction so far has been skeptical to say the least. While proponents point to numerous examples of similar charitable donation programs already in place in many states, others argue that these examples do not establish a clear precedent for as expansive a program as envisioned by New York legislators.
As long as there is a limit on the deduction for state and local taxes with no comparable cap on charitable contributions, state and local governments will have an incentive to recharacterize tax payments as charitable contributions. The irony, of course, is that state and local taxes support spending that is at least as much in the public interest as the activities of private charities supported by charitable contributions.
The workability of the payroll tax program has yet to be tested. While it is less likely that the IRS will intervene (although it could find that the voluntary employer payroll tax is simply payment of employee tax obligations, akin to withholding of state income taxes), its success will depend on buy-in from both employers and workers. The Wall Street Journal surveyed large employers in the state and found that none were interested as yet in participating.
The new program may also portend a shift in the tax structures of state and local governments. If taxes paid by business are fully deductible while the deduction for taxes paid by individuals is limited, state and local governments will be tempted to shift more of their taxes to businesses. States may boost payroll taxes as an alternative to individual income taxes. Or they may consider gross receipts taxes or even a value-added tax as viable alternatives to only partially-deductible retail sales taxes.
The TCJA is littered with disparate treatment of different types of income, creating incentives for taxpayers to recharacterize income into its most tax-advantaged form. We may see the same behavior by subnational governments in response to the disparate treatment of different types of payments made to support state and local government programs.
This post was updated on May 21st, 2018 to clarify the type of credit taypayers who contribute to the NY state fund will receive.
Posts and comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.
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