State and Local Income Tax Deduction: Some Answers, More Questions

Last week, I wrote a number of posts (see here for example) raising concerns about possible loopholes in the limitation on state and local income tax deduction in the House tax bill. Since then, there have been a number of developments — some answering questions colleagues and I raised and others raising new questions — about what is among the largest offsets in the entire legislation. To briefly sum up, one loophole, for pass-through owners to continue deducting state and local income taxes as an itemized deduction, seems to be foreclosed. However, there remain very real concerns that a significant share of the revenue now expected from limiting this deduction may simply not materialize, meaning the bill could add more to the deficit and be more regressive than is now reflected in official estimates.

As I wrote before, a number of NYU colleagues and I were concerned that the House bill would’ve allowed owners of pass-through firms and investors to continue to write off their state and local individual income taxes as itemized deductions even as employees couldn’t. After waffling and perhaps after coming to the realization that the revenue estimate was inconsistent with the policy they may have been proposing, Republican tax writers clarified that they didn’t mean for this to happen — though, in its haste, the Ways and Means Committee left somewhat of a mess behind in the legislative language.

In the meantime, however, a number of commentators have raised additional questions — focused on how states and localities could adapt their tax systems — as to whether this limitation would in fact generate the roughly $1 trillion that JCT now estimates. From what I can tell, this estimate does not take into account the likely reaction of states and localities restructuring their taxes to maintain deductibility — which means JCT could be substantially overestimating the tax increase from this provision (and thus under-stating the amount the tax bill adds to the deficit).

Some Answers

Since I last wrote, there have been some answers provided by the tax writers to questions raised by my colleagues and me:

· First, in responding to our concerns and questions from both the press and Democratic members of the Ways and Means Committee, Republican tax writers from the Ways and Means Committee first waffled and seemed to suggest that itemized deductions for state and local income taxes would still be allowed for pass throughs (also seemingly consistent with the legislative text), before finally reversing. In a letter from Chairman Brady to Representative Blumenauer, Brady basically blamed the Joint Committee on Taxation (JCT) for any confusion. He suggested that JCT had made a mistake in its description of the limitation and that, contrary to that description, the state and local income tax deduction would not be allowed to anyone taking it as an “itemized” deduction, irrespective of whether the taxes were paid on income coming from a business or investment. While the JCT description did in fact seem like a reasonable reading of the legislative text absent clear legislative history indicating otherwise, this at least ended the debate as to what Ways and Means now intends for this to do. (Though if that’s what they really intend, suggestion: Change the legislative text also to clearly reflect that policy and to remove any ambiguity. Someone at JCT, after all, read the very same language and came to a different conclusion, perhaps consistent with what the Committee may have intended to do before the scoring effects became clear.)

· Second, the new Senate Finance Committee draft seems clear on the matter. In fact, the Senate adopted — in their description — something very close to the language that my colleagues and I suggested in our last post: the “conceptual bill” description states that legislation would deny the state and local income tax to any individual, flat out — and apparently irrespective of whether paid in carrying on a trade or business or holding an investment. If reflected in the legislative language, that would clearly bar any individual — whether receiving pass through income or not — from deducting state and local income taxes, whether above the line or as an itemized deduction.

More Questions

However, that leaves a number of significant questions for the tax writers and JCT that remain unanswered about the limitation. In particular, from what I can tell, JCT does not seem to be taking into account how state and local governments can restructure their tax systems to preserve deductibility. There are several ways they could do this:

· One is by imposing taxes on pass throughs entities (like the NYC unincorporated business income tax) and potentially crediting those taxes on individual tax returns. This could essentially preserve the deduction for pass-through owners, at least under the House version of the limitation. Under current law, these taxes imposed on pass through entities can still be deducted “above-the-line” (not as an itemized deduction but deducted before that on business income schedules to arrive at “adjusted gross income”). The House language still seems to preserve this deduction. The Senate does not — if it really does bar the deduction to any individual whether “above-the-line” or as an itemized deduction. If the above-the-line deduction is preserved as it is apparently in the House bill, this gives states and localities a way to restructure taxes on owners to make them deductible: Impose tax on the income of the “business” rather than the “individual.” And, if you want to hold the individual largely harmless, give a credit at the individual level for taxes paid at the business level. (The NYC unincoporated business income tax already features a partial credit like this, as my colleagues and I described here.)

· Another route for preserving deductibility is by encouraging people to make gifts to state and local governments. Such gifts are deductible under the Code — as Manoj Viswanathan explains. And States could then credit up to 100 percent of the gifts made to the state and local government against individual taxes owed. In that way, deductibility of state and local taxes could essentially be preserved for those high up in the income spectrum and who are likely to still be itemizing as a result— through the charitable deduction. For those thinking that it couldn’t work that way: Manoj describes a line of cases that have allowed just such schemes when it comes to new state laws giving individual income tax credits for amounts donated to private schools. This, among other things, created a work around for those limited in their deduction for state and local income taxes by the AMT. There’s been litigation and, so far, taxpayers have been allowed their charitable deduction, despite the fact they get an individual income tax credit in exchange for making the donation.

· Finally, as Daniel Hemel has pointed out, states could also restructure their income taxes to be employer-paid payroll taxes. Most economists believe that the incidence of such payroll taxes eventually falls on employees, like an income tax directly imposed on an employee. And, such payroll taxes would remain deductible for the businesses — even as the resulting reduction in wages would reduce employees’ taxable income. The result is very similar to preserving the individual level deduction to begin with. To the degree states wanted to preserve progressivity in their income tax systems, they could again fall back on credits — and offer refundable credits at the individual level to filers, modulating the progressivity of their combined system to the degree they desire.

In scoring, both CBO and JCT rightly have in the past taken into account state and local responses to fiscal policies. The same should be true here, though that doesn’t seem to be the case with current scores. If one of the largest revenue raisers in the entire bill — and one that is supposed to be disproportionately paid by the highest income Americans — is going to be effectively avoided, policymakers and the public should know about it.