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The Tax Cuts and Jobs Act (TCJA) limits the itemized deduction for state and local taxes (SALT) on federal individual income tax returns to $10,000. Many high-tax states, including New York, see it as a politically motivated assault that will undermine their ability to fund essential public services. In response, these states are developing creative options aimed at circumventing the limits. However, if they are not careful, they could create a complex web of state tax benefits that mostly help the well-to-do, exacerbate the federal government’s fiscal woes, and may lead to unintended consequences.
A bit of background: First, the vast majority of people, even in high tax states, will pay lower taxes under the new law until the individual income tax cuts expire in 2025. The $10,000 limit is one progressive element of a law that disproportionately benefits the rich. In 2018, 96 percent of the additional tax from the limitation of the SALT deduction falls on the top 20 percent of taxpayers and 57 percent on the top one percent. It also raises a lot of money—nearly $650 billion over 10 years.
Second, states fear that limiting the federal SALT deduction will increase pressure to lower their taxes, reducing support for spending on safety net programs that benefit low- and moderate-income residents. However, there is little empirical evidence that federal income tax deductibility directly impacts peoples’ willingness to pay higher state taxes. For example, the value of the deduction has risen and fallen several times as federal tax rates have changed, with little response by either the states or their high-income residents, although states did lobby successfully to partially restore the federal deduction for states sales taxes that had been eliminated in 1986.
Even before TCJA, relatively few taxpayers could fully deduct state and local taxes. Only 30 percent of households itemized deductions under prior law and thus most got no direct benefit from the SALT deduction. Many higher-income households —especially those with a lot of SALT—were on the Alternative Minimum Tax (AMT), which reduced or eliminated the deduction’s value.
Still, states are exploring several ways for taxpayers who face the SALT deduction cap to deduct those taxes in other ways. One proposal would reduce state income taxes but make up that revenue with state-imposed employer payroll taxes, which remain deductible under the new law. States already use payroll taxes to fund programs such as unemployment insurance and some disability benefits. This option basically relabels withholding taxes (also remitted by employers) as payroll taxes. If broadly applied, it would extend deductibility of state taxes to all workers, not just those who itemize.
An alternative would give taxpayers an income tax credit or deduction for donating to charitable organizations that support specific state and local programs, such as funding for K–12 education. If the credit equals 100 percent of their donation, contributors would see their income after state taxes unchanged but could deduct charitable gifts on their federal income tax return (assuming their itemized deductions exceed the standard deduction).
Many similar charitable donation programs already exist. Over thirty states provide tax credits or deductions for contributions to special funds, such as those that support private school tuition. Donors claim a full federal income tax deduction even if their net cost after the state tax credits is negligible. The federal and state tax breaks together can result in a windfall for the “donor” that makes no sense as tax policy, but is permitted under current law.
Is it okay for states to devise their own plans to reduce the federal taxes of their residents without explicit authorization from Congress? Smart lawyers (Hemel on the payroll tax; Bankman and colleagues on the charitable deduction) have argued that these techniques are perfectly legal.
But that doesn’t make them good policy. Absent very careful design, the payroll tax option could have unintended consequences. For example, the employer payroll tax could lower wages by the amount of the tax, keeping total compensation constant. But lowering wages would reduce federal tax benefits such as the EITC and the child tax credit for some households. The excellent New York state report addresses these and other issues and proposes plausible solutions, but they come at the cost of significant additional complexity.
These proposals create another real risk. Congress has already voted once to limit the SALT deduction and could pass legislation declaring the new proposals invalid. If Congress disallows charitable deductions that are offset by tax credits, several existing state programs also could be invalidated. The Treasury Department and IRS also could block the deductions. Treasury’s Tax Legislative Counsel recently questioned some of these proposals.
If widely adopted and successful, the plans could significantly reduce federal revenue and most of the benefits would go to taxpayers with high incomes. They may be legally defensible, but they raise important questions about the interaction between federal and state taxes that policymakers at all levels need to address.
Posts and comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.
Hans Pennink/AP Photo