Implementing a State-Level Payroll Tax in Response to the Rollback of SALT
The devil is in the details. Here are a few thoughts on how to make it work
Vox’s Dylan Matthews published an excellent article this morning explaining how states can circumvent new limits on the state and local tax (SALT) deduction by shifting toward employer-side payroll taxes, which remain fully deductible under the new tax law. (For more on the subject, see this earlier post.) As the idea gains traction in Albany, Sacramento, and elsewhere, I thought I’d offer a few further suggestions on implementation for state lawmakers considering such a change. But before doing so, four quick notes on why states should take this idea seriously:
— (1) Shifting toward an employer-side payroll tax would potentially benefit workers regardless of whether they claim the standard deduction or itemize. If you claim the standard deduction, then you’re still including in your gross income — and being taxed on — the amount that you pay in state income taxes. If states raise more of their revenue through employer-side payroll taxes rather than state income taxes, then workers will pay less in federal taxes on amounts that ultimately go to the state.
— (2) Aside from a parochial interest in wanting to reduce their residents’ federal income tax liability, there are good policy reasons for states to try to preserve the ability of their residents to pay for public services with pre-federal-tax dollars. The number one expenditure for state and local governments is education — i.e., investment in human capital. The new tax law shifts toward expensing (i.e., immediate deduction) for physical capital. In an increasingly knowledge-based economy, it makes no sense to deny the same treatment to investments in human capital too. The largest other single expenditure for state and local governments is health care, which can be paid for with pre-federal-tax dollars if purchased through one’s employer. Why favor employer-sponsored health care over state-financed health care? And more generally, the new tax law retains the deduction for charitable contributions while limiting the deduction for state and local taxes. Why should I be allowed a deduction for amounts I pay to my synagogue and not for amounts that I pay to my city? If the goal of the charitable contribution deduction is to subsidize the supply of public goods, well, states and localities do that just as much as 501(c)(3) organizations (if not more so).
(For more on arguments for and against the SALT deduction, see here.)
— (3) For states and localities that want to fight back against the Republican tax bill, this is a much more promising path than the litigation route. The Sixteenth Amendment allows Congress to tax incomes from whatever source derived, and the Supreme Court has said many times that deductions are a “matter of legislative grace.” That makes it very difficult to argue that a deduction for state and local taxes is constitutionally required. (Not to mention the fact that the deduction for state and local taxes already has been limited for decades by the alternative minimum tax, with nary a constitutional doubt.) Perhaps one can argue — as Michael Dorf has suggested — that the new limits on SALT violate the First Amendment or the equal sovereignty of the states because they were enacted out of political animus. But as Dorf acknowledges, proving this to the satisfaction of a federal court would be very difficult. Changing the structure of a state tax system is quite a bit easier.
— (4) Yes, this would require careful thought and some administrative hassle at the implementation stage, but a lot of money is on the line. New York State raises about $50 billion a year in personal income taxes. Back-of-the-envelope calculation: Salaries and wages are about three quarters of household income, and this proposal would shift that from post-federal-tax to pre-federal-tax. Assuming (conservatively) an average marginal rate of 24%, then the potential savings to New York are about $9 billion a year, or more than $1200 per household. (I’m assuming, realistically, that almost all itemizers in the state will run into the new $10,000 SALT cap on the basis of property taxes alone, and so very few New Yorkers will be deducting personal income taxes under the new regime.) Illinois, which raises somewhere around $20 billion a year in income taxes (following a recent rate hike), would save somewhere in the range of $3.6 billion a year, or about $750 per household.
OK, so how might we actually do this? A few thoughts on implementation:
— (1) The easiest way to implement this would be through an employer-side payroll tax and an offsetting employee-side wage credit (which would be fully refundable). In Illinois, where the state income tax rate is a flat 4.95%, that would mean imposing a payroll tax on Illinois employers of 5.208% x wages and allowing individuals to claim a credit of 4.95% x wages earned in Illinois. Thus, if my employer previously paid me $100, it could instead pay me $95.05, then pay 5.208% x $95.05 = $4.95 to the state, and its out-of-pocket costs would remain the same ($95.05 + $4.95 = $100.00). My gross income for federal and state income tax purposes would be $95.05, and my state wage credit (4.95% x $95.05) would perfectly offset my state income tax liability (4.95% x $95.05). (The refundable credit should be made available to nonresidents who earn wages in Illinois — e.g., commuters from northwest Indiana to Chicago — so as to avoid potential Dormant Commerce Clause objections.)
— (2) States would not have to (and should not) repeal their state income taxes in order to do this. They don’t even have to alter the existing rates (though they’ll presumably want to adjust their withholding tables). My wage credit would offset state income tax liability with respect to wages earned in Illinois, but I’d still be taxed on income from out of state, as well as on self-employment and investment income not subject to the payroll tax.
— (3) This would not mean the end of state income tax filing. But there are other ways that states can — if they have the political will — dramatically reduce the burden of tax filing for most of their residents. (See, in particular, Joseph Bankman’s work on pre-populated state income tax returns.) As a practical matter, most wage-earners would owe nothing or get state tax refunds because their wage credits would offset their state income tax liability. But that’s already the case under current law because of employer-side withholding. Also, keeping state income tax laws in place means that various state tax expenditures — such as state earned income tax credits and incentives for contributions to section 529 college savings plans — would continue to operate as before.
— (4) States with progressive rate structures could implement the payroll tax and wage credit in one of two ways. One would be to pick a rate that’s roughly equal to the effective state income tax rate for median-income households. That would mean that lower-income households would have wage credits in excess of their state income tax liabilities and would receive refunds, while higher-income households still would owe some state income taxes. Another possibility would be to implement a progressive rate structure that matches the rates for single taxpayers. In New York, that’s 4% times the first $8,500, plus 4.5% times the next $3,200, and so on . . . . (Actually, for complicated reasons, New York would probably want the payroll tax to be 4.167% times the first $8,160 in wages, plus 4.712% times the next $3,056, etc., so that the payroll tax on the tax-exclusive base matches the income tax on a tax-inclusive base.) The wage credit then would also be progressive and would be calculated separately for each job. Married couples might end up owing a bit more or a bit less than the sum of their wage credits and would square up with the state when they file their annual returns.
States with flat taxes don’t have to worry about these complications. (Those include Colorado, Indiana, Massachusetts, Michigan, North Carolina, Pennsylvania, and Utah, as well as my home state of Illinois.) I think a flat state income tax is a terrible policy for other reasons, but it does make implementation quite a bit easier here.
— (5) For my employer to be no worse off under this system than under the status quo, my wage would have to drop by the amount of the new payroll tax. As Dylan points out, wage stickiness might stand in the way of that. In his view, that’s a feature rather than a bug because it would lead to a one-time wage hike. (If I previously earned $100 and owed $4.95 in state income taxes, and now I earn $100 and owe nothing in state income taxes after I apply the wage credit, then I’m $4.95 better off.) But if employer resistance is an obstacle, then states could phase the credit in over several years. For example, Illinois could implement a 2% payroll tax with an offsetting credit in 2018, rising to 4% in 2019 and 4.95% in 2020. As long as inflation remains above 2%, my employer could continue to pay the same in real terms as the tax phases in without ever cutting my nominal wage.
— (6) Is there a risk that the IRS will argue that the employer-side payroll tax is really an employer’s payment of taxes on the employee’s behalf, in which case the employer’s payment still would be includible in the employee’s gross income for federal tax purposes? Perhaps, but I am aware of no precedent for the position that payroll taxes imposed on and paid by an employer count as income to the employee. Still, states that implement this strategy would be well advised to consult the IRS beforehand.
— (7) This proposal could operate in tandem with — rather than to the exclusion of — a program along the lines suggested by Phillip Blackman, Kirk Stark, and Manoj Viswanathan that would allow taxpayers to make charitable contributions to state institutions and then credit those contributions against state income taxes. (The IRS has said that taxpayers can deduct those payments as charitable contributions rather than as state taxes — which would effectively free them from the $10,000 SALT cap.) In particular, individuals with non-wage earnings still would face positive state income tax liability under the payroll-and-wage-credit proposal, which they could offset through charitable contributions. The advantage of combining these two proposals rather than just implementing the charitable contribution option is that the payroll-and-wage-credit idea benefits the vast majority of taxpayers who will claim the standard deduction under the new tax law, while the charitable contribution option only benefits itemizers.