Another Way the Empire [State] Can Strike Back

Or why states should tax Qualified Business Income

There has already been a fair amount written on how states can restructure their tax systems so as to retain the benefit of the state and local tax (SALT) deduction for their residents. I helped craft a summary of three proposals here; see further discussion by Brian Galle here and here. Daniel Hemel has already expanded the discussion to other useful expedients the states can adopt here. California has expressed interest in the expedient of increasing the use of charitable contributions. Today, the big news is that New York is also considering expanded use of the payroll tax.

In this post, I will further develop the third option that has been kicking around, and the one that I have seen least considered to date, despite what I take to believe several extremely positive features.

The proposal at issue, and it was first developed by David Kamin here, is for states to increase their taxes on the income generated by pass-throughs. Why should states do this? Here are the two reasons that we have focused on so far.

1. Taxes imposed on the entity level will remain deductible and thus this is a way for states to shift their tax base towards taxes that remain deductible at the federal level. This is the same strategy underlying the shift to the payroll tax and the greater use of charitable deductions.

2. Taxing pass-through income, precisely because the income is passed through to the taxpayer, is a means of taxing income progressively. This is appealing in the abstract and also because of the overall regressive nature of the recent tax changes, especially when taking into account how these pass-through rules will be manipulated by the well advised.

But there are some more reasons for states to tax pass-throughs.

3. It might seem daunting to design a new tax on businesses, but the design of such a tax can be (relatively) straightforward: impose a state tax on “Qualified Business Income” (QBI) at the business entity level. The new federal tax law does not impose a lower tax on pass-through income per se, but instead permits taxpayers a 20% deduction on their income that is QBI (with various limitations). The new law distinguishes between types of QBI — and limits QBI — at the level of the business entity. Thus, even though the new law uses QBI to give certain fortunate taxpayers a tax break on their individual returns, QBI is calculated at the entity level, more or less, and can be taxed there. Though there are complexities because the QBI calculations are complex, this solution is administratively elegant because it obviates the need for states to impose a general entity-level tax on some new tax base, but can focus on directly taxing the kind of income that is being privileged by the new federal tax law. In fact, there are various distinctions made within the broader category of QBI, distinctions that the states could use further to refine their tax rates on QBI. More on this in a moment.

4. If the states were to impose a small surcharge on QBI, then this would be an efficient tax base to tax. Ok, here is a spoonful of tax theory to explain that last sentence. In general, it is more efficient to tax things that are hard to hide (property) or stop doing (earning a salary, for most people). It is less efficient to tax things that are easy to hide (cash tips) or avoid doing (eating pistachio ice cream or building windows). Taxpayers are going to be given a large incentive to generate QBI by the federal government, too much. A small state tax on QBI will not cause much avoidance of producing QBI given the big federal incentive taxpayers will have to generate more QBI, not less. (To the extent that the state tax causes a taxpayer to act so as to avoid paying tax on state and federal QBI, then this is an instance of what David Gamage and I call tax cannibalization.)

5. But maybe it is ok to tax away a lot of the federal benefit being given to QBI. If that is the case, then maybe a big state tax on QBI is justified. (Keep in mind that at its maximum, the federal changes permits a 20% deduction of QBI, which means that a taxpayer that would otherwise owe tax at a rate of 37% will now pay 29.6%. Thus, for instance, a 5% tax on QBI would eat up a substantial percentage of the federal benefit.)

Ok, a bit more theory. Often, when we impose a tax on something we do not want people to stop doing it. This is surely the case when it comes to earning income or buying things. If QBI is like income in general, then we want to tax it but not too much. Sometimes, however, we do want to stop the taxed activity or at least suppress it, say when we impose a tax on cigarettes.

I suggest that QBI is a bit of a hybrid. On the one hand, we certainly do want businesses to keep earning income, including QBI, but do states really want taxpayers to retain any of the tax benefit conferred by the federal government on this special kind of income? The federal privileging of certain types of QBI is arguably as good for the states as smoking. As Dan Shaviro has argued here and in many other places, there is no good reason for the tax code to anoint certain kinds of income as worthy of a lower rate.

Let’s go a bit deeper and consider QBI generated by investments in real estate. Remember what this means. In effect, investment in a capital intensive activity is generating income that is taxed at a special low rate, a rate lower, for example, than the rate a doctor would pay earning the same income. There is barely even an implausible story that privileging real estate income in this way is going to create jobs, especially in many states where overheated real estate markets are a primary reason that people cannot afford to stay in state and take good jobs. This is not to say that a state should discourage investment in real estate in general, as clearly investments in denser housing is required, but states have a good reason to discourage tax-break driven inflation in real estate prices. As to QBI generated by real estate then, why should a state not tax it at 8% and more than wipe out the federal benefit? The revenue generated could be used to build affordable housing.

But what of interstate competition you might ask? That is, if New York imposed a high tax on QBI or certain QBI, then might this not lead, at the margin, to firms moving to New Jersey or Connecticut? There are a few responses. First, as to the QBI generated by, say, real estate, the interstate mobility issue is rather muted. To take a random example, where will Trump Tower and its QBI move to? Second, states use formulas to apportion income from multistate businesses, usually by the location of sales. Unless a firm wants to give up its New York sales, moving to New Jersey will not help, at least as to the new QBI tax.

Third, perhaps New Jersey and Connecticut, (and Pennsylvania and Maryland and Massachusetts and Illinois and California…) don’t want to win interstate competition by undermining their neighbors surcharge on QBI. If all these states were all to impose an identically structured tax on QBI then they would all raise revenue efficiently and suppress regressive economic distortions. Indeed, they would in essence be raising the revenue the federal government has left on the table. They could use that revenue to support those people the federal government has left in the cold, from immigrants to those relying on ACA exchanges for health insurance to, yes, doctors who are going to take a big tax hit on account of the partial repeal of the SALT deduction.

But maybe the states agreeing to a ceasefire seems too improbable, even in the age of Trump. Ok, fine. States should still tax QBI at a low rate and QBI generated by real estate at a higher rate.

(Final in the weeds parenthetical. In earlier versions of the tax bills, there was a question whether an entity level income tax could still be deducted. In the final bill, the matter is still unclear, but, to my mind, supports deductibility, especially if the new tax is not structured to mimic an individual income tax too precisely. And that is what I am proposing. The tax should only be on larger businesses, with limited credits for lower and moderate-income individuals. Given such a structure, the tax would not be an income tax on individuals; further details about this will need to await another post. But note that the proposed tax would (roughly) resemble Texas’ Margin Tax, which the Texas Supreme Court found was not an income tax for purposes of Texas state law. See story here.)