Repeal of the SALT Deduction for Income Taxes Might Not Raise a Cent

The House Republicans’ plan to partially repeal the state and local tax deduction is barely a week old and already tax professors have found a number of gaping holes in the proposal. For excellent posts on the subject, read co-blogger David Kamin’s writing here as well as Manoj Viswanathan over at The Surly Subgroup. To pile on, I’ll add one more way that states could game the House proposal — a strategy that could come quite close to offsetting the effects of SALT repeal entirely. (Thanks to David for helping me think this through.)

While there is quite a bit of controversy about whether sole proprietors, partners, LLC members, and S corp shareholders will be able to deduct state and local income taxes attributable to a trade or business (see David’s most recent post for more), there is no controversy as to whether employers can deduct state and local payroll taxes. They can. The House bill does not touch the deduction for state and local taxes other than real property, personal property, and income taxes. Payroll taxes are state and local taxes other than real property, personal property, and income taxes. When paid by an employer, they’re deductible under current law and remain so under the House bill. (The same is true with respect to the Senate bill released this evening.)

So if either the House or Senate bill becomes law, jurisdictions that now impose income taxes would be well advised to shift some of their revenue-raising to employer-side payroll taxes. For example, Illinois now imposes a flat income tax of 4.95%. Of the next $100 I earn in wages, $4.95 will go to the state and $95.05 will go to me (before federal taxes). Now imagine if instead the state imposed a 5.208% payroll tax on employers. My employer would pay me $95.05 and then pay 5.208% x $95.05 = $4.95 to the state.

The employer would still have a $100 federal income tax deduction: $95.05 in wages + $4.95 in state payroll taxes. (It’s a little funny to make this a first-person example because my employer, the University of Chicago, is tax-exempt.) My federal taxable income would be $95.05, the same as if I could claim the SALT deduction. Everyone is just as happy as before — except that partial repeal of SALT has raised zero for the federal government. Actually, it’s raised less than zero — for two reasons: First, state income taxes currently aren’t deductible for Social Security and Medicare tax purposes, so if Illinois shifts to an employer-side payroll tax, the federal government would collect slightly less in Social Security and Medicare taxes from employees in Illinois. Second, the deduction for state income taxes currently isn’t available to folks who claim the standard deduction, but those taxpayers would benefit from my proposed workaround too.

Illinois could leave in place its existing 4.95% tax on self-employment and investment income, so it would be raising the same amount of money as before. Things get a little bit more complicated for states with progressive income taxes — but not that much more complicated. States like New York and California could impose an employer-side payroll tax pegged to the top marginal rate in the state and allow individuals to claim a refundable credit against state income taxes equal to the payroll taxes paid on their behalf.

The key point here is that a state, through a relatively straightforward legislative maneuver, could entirely negate the effect of the House or Senate proposal with respect to state and local income taxes paid on wage income (which is more than two-thirds of all household income). And given that this maneuver would make state taxes excludible for non-itemizers as well, the net effect could even be to lose money for the federal government.

One might ask why states don’t do this already. Even under current law, there are several advantages to states if they raise revenue through payroll taxes rather than personal income taxes: lower Social Security and Medicare taxes for all wage-earners; avoidance of the alternative minimum tax and the effects of the Pease provision for high earners; and exclusion of state taxes for workers who take the standard deduction. While it’s a bit of a mystery, the best explanation is probably that the benefits aren’t yet enough to motivate states to rearrange their tax systems, given that the people who pay the lion’s share of state income taxes are itemizers who can claim the SALT deduction. Take away the SALT deduction for income taxes, though, and suddenly the motivation to shift away from a state income tax and toward a state payroll tax becomes much more powerful.