State SALT Fixes, Part III: Payroll Tax & Credit

This week I’m looking at three major proposals for states to respond to partial repeal of the federal tax deduction for state & local taxes. The first post covered some background and evaluated a plan to use the charitable contribution deduction in place of the SALT deduction. Yesterday we discussed the possibility of replacing state income taxes with a payroll tax. (Also, in case you missed it, see Darien Shanske’s cool idea for states to recapture some revenue lost to the the new Act). Today, a variation on the payroll tax plan:

Salary Upcycling

A third proposal, detailed here at WSD by Daniel Hemel, has much in common with “repeal and replace.” Like Baker, Hemel proposes a new state payroll tax. In Hemel’s plan, though, the state does not repeal its income tax. Instead, all of the revenues from the payroll tax are used to fund a “wage subsidy” in the exact amount of the payroll tax collected for each worker (Victor Thuronyi , the former IMF tax counsel, also argues for this kind of plan in his comments to my last post).

Hemel’s idea works through a kind of tax alchemy. Salary, of course, is federally taxable, but there is an (mostly unwritten) exception from the federal tax base for government benefits. For instance, the federal government does not tax state-delivered Medicaid premium payments or TANF benefits. In Hemel’s view, the wage subsidy would qualify as exempt income under this rule or other similar provisions, allowing the state to in effect convert (or upcycle, as I call it) taxable salary into tax-exempt wage subsidies.

For example, suppose Daniel earns $1m in 2017, paying $100k to Illinois and (after 30% federal tax and a SALT deduction) $270k to the feds. He takes home $630k. Next, TWNN is enacted and Illinois adopts the salary upcycling plan. In 2018 IL sets payroll tax rates so that, after expected salary adjustments, Daniel’s employer UC will pay $100k in payroll taxes. Daniel’s salary falls to $900k. He pays $270k in taxes to the federal government, and (assuming IL adjusts income-tax rates to hold revenue constant) $100k in income taxes to IL. So far, he has $530k. But he also receives a $100k wage subsidy, leaving him once more at $630k. This $100k is (arguably) not subject to federal tax under the government benefits doctrine.

There is a lot to like about this proposal as compared to its two alternatives. Unlike repeal and replace, it leaves the state’s income tax system mostly intact, avoiding the administrative upheaval and individualization problems we just discussed (though it too has some inter-state coordination issues to resolve). And it could not be erased as readily by a possibly antagonistic federal Treasury.

But this is not to say the plan is without legal challenges. There are recent Tax Court decisions (surveyed in this old Hemel post) holding that mere reductions in taxes due to another sovereign do not create federally taxable income. Refundable credits in excess of taxes currently due to the other sovereign are taxable, though. To maximize federal tax benefits, a wage credit should probably be structured as a non-refundable income tax credit, with excess amounts rolled over to later years. This mechanism could be partially replicated for high-earning taxpayers in places like Washington and Texas, whose combined sales and property tax deductions exceed $10,000. Credits against property taxes are easy to implement, but it’s not clear how Texas could readily credit back individual sales taxes due.

As I just mentioned, another potential argument for excluding wage subsidies, even if not structured as tax rebates, would be to rely on longstanding nonstatutory exclusion from federal tax for certain state benefits. Usually this exception applies to safety-net type programs that depend on some measure of need, though the IRS has also described the policy as covering payments “for the general welfare,” (e.g., RR 74–205) which in related contexts usually means services that weren’t purchased for the use of a particular payor (e.g., payments to the city water utility).

As with the charitable deduction plan, there is some potential vulnerability here to an unsympathetic Treasury. There is not an obvious clear tax theory or economic rationale for treating tax reductions differently than other “accessions to wealth” the tax system usually includes in income. Ignoring tax credits to the extent they reduce other income might be defended as simplifying: surely *some* tax deductions authorized by other governments, such as the costs of doing business, should not be federally taxable in the U.S., and a blanket exclusion rule avoids the need to make distinctions. But one could imagine that the Treasury could, with appropriate administrative guidance, carve out particular instances of tax benefit from this general background rule. Some Supreme Court language suggests the Court might require a clear statement before recognizing non-federal tax reductions as federal taxable income, but it is unclear if such a clear statement must be made by Congress itself (for a deep dive on when clear statement rules should have to come from Congress instead of an agency, see here).

Still, it is reassuring that current law probably is mostly consistent with the upcycling proposal. Regulatory guidance formal enough to overturn existing precedent takes some time, especially for an agency as understaffed as IRS is right now.

Reliance on the government-benefits exclusion could similarly be fragile in the long run. Again, there is no statutory provision authorizing the exclusion of government benefits from federal taxable income. The legal basis for exclusion seems to rest on IRS determinations from a very different era in the constitutional law of federalism. In particular, old IRS guidance suggests that there is a constitutional doubt whether the U.S. can impose taxes on state government programs, and in essence imposes a clear-statement rule requiring that any tax on state programs be explicitly required by Congress. Developments after 1937 make clear that in fact there is probably no such constitutional limit, rendering the clear-statement rule likely unnecessary (clear statements are required when there is “doubt” about an agency’s authority to enact a policy, see Foster v. Dulles). In short, there is probably nothing that would prohibit Treasury from issuing a new regulation imposing tax on upcycled wage subsidies.