Sustainable Solutions for SALT

Or Why Congress Should Fix This Mess

One of the main revenue raisers in the 2017 tax legislation was a limitation on the deductibility of state and local taxes (SALT). And, recent months have seen considerable controversy erupt around states changing their tax systems in order to try to try to avoid this limitation and preserve deductibility — as a number of us predicted that states would before the legislation was even enacted.

The debate regarding these “workarounds” has focused largely on two questions: First, whether the state maneuvers pass legal muster. And, second, whether or not these state tax changes would benefit almost exclusively the top of the income spectrum who will directly take advantage — or instead have broader benefits within the relevant states by encouraging states to maintain progressive tax systems financing transfers, investments, and services.

In this post, I want to add a third issue to the mix, an issue that I think should be at the center of the debate going forward: How should Congress fix the mess it has made. This limitation was ill-thought through from the start. In designing the 2017 legislation, Congress did not carefully consider the relationship among state and local taxes paid by individuals, state and local taxes paid by businesses, and charitable giving (nor the underlying justifications for the SALT deduction). The statehouse race to restructure is the result.

The SALT reform should be reformed — by Congress. The question is what that should look like. One possibility and one that I think would be considerably better than the current mess is a limitation that applies more comprehensively — to charitable giving and taxes paid by businesses too — while allowing more SALT deductibility for individuals than we have now.

The Maneuvers

The 2017 tax law imposes a $10,000 cap on the deductibility of state and local income and property taxes paid by individuals. States have been exploring three ways to try to preserve greater deductibility, all of which scholars (including myself) wrote about in the few short weeks that the 2017 tax legislation was under consideration:

· Charitable giving. States are setting up charitable funds to which residents can contribute. The gifts may remain tax deductible as a charitable gift even as the state then provides a tax credit based on the amount donated — offsetting individual income tax. It is essentially a swap of one payment that remains deductible (charitable gifts) for another with very limited deductibility (individual income tax). California is also considering a version where the credit comes from making a gift to an eligible non-profit and the non-profit essentially pays back the state by reducing the amount of funding it receives or making a direct payment.

At this point, at the least, New York, New Jersey, and Connecticut have adopted versions of this.

· Employer payroll taxes. This involves having the employer pay employer-side payroll taxes on wages and then reducing individual income taxes on those wages to offset via a tax credit. Again, it swaps payments that are essentially fully deductible for ones that aren’t.

New York has now adopted a version of this.

· Unincorporated business taxes. This involves taxing pass through entities at the entity level and then reducing the individual income taxes paid on that pass-through income at the individual level, again through a tax credit. Once more, it is a swap of payments that are apparently deductible for ones that are subject to the $10,000 limit.

Connecticut has adopted a version of this.

The Debate Up Until Now

The debate so far has largely focused on whether the maneuvers work legally and whether states doing them are simply rewarding the highest income residents who already benefited from the tax bill (even if less than their high-income peers in low tax states).

But, so far, the discussion hasn’t focused much on what Congress should do. And that’s a problem, for two reasons.

First, as a legal matter, some of these maneuvers are likely to end up working. For purposes of this post, I’m not going to engage the considerable debate about which ones will pass legal muster. There are arguments on both sides with regard to each, and the strength of the arguments vary depending on the particular details of the state laws. Suffice it to say that I expect that some of these methods to preserve deductibility will be upheld (even as others may fall), and states are then likely to copy the structures that are working.

Second, states have large incentives to explore these options. They can unilaterally reduce the cost of taxes — or close equivalents — being paid to them by their residents, with billions per year on the line. The direct effects are very skewed toward the top, but, by reducing the cost of the taxes, the states may be able to more easily maintain progressive and robust tax systems that accrue to the benefit of the residents broadly. Those are pretty good reasons for states to explore these structures.

However, this doesn’t mean that Congress should leave the law as it is. These maneuvers will potentially cost significant federal revenues and lead more states toward inefficient tax planning. Further, revenue saved from Congress revisiting SALT and addressing these workarounds can be put to ends that we know with confidence are progressive, though putting the revenue to progressive ends is unlikely to happen with this particular Congress or president. Just because it makes sense for a state to engage in this planning doesn’t mean that Congress should have created the incentive for states to act this way. There is a difference between the interests of a state and the country, and, if we’re going to allow a partial SALT deduction, then it should be done in a rational fashion.

Congress Should Fix the Mess

So, a focus of this debate should be on how Congress can fix this mess. Here’s my preliminary view: Restore a partial deduction for SALT, so that every dollar paid gets a certain amount of value as a deduction. That’s unlike the cap now where there’s no tax value to income or property tax payments in excess of the $10,000 for an individual per year. President Obama had proposed a cap that worked something like this — capping the value of SALT and other individual tax expenditures at 28 cents on the dollar.

Importantly, the cap should be applied across the board to all of the items that are potentially substitutes for individual payments of SALT. That includes charitable gifts and taxes paid by businesses.

In the case of SALT, I tend to think a partial deduction of this variety is actually right as a policy matter. Some of SALT goes to payments for services from which the taxpayers themselves directly benefit. Those amounts for the most part should not be deductible. Some of it goes to investments, services, and transfers that benefit others; those probably should be deductible. So, rough justice is a partial deduction of this variety — one reflecting the mixed nature of SALT and beyond the current $10,000 cap.

The same could be said for charitable gifts, some of which we wish to encourage and others which are less compelling to subsidize (such as the increased “gifts” to universities in the lead up to one’s children applying — that doesn’t seem like such a great thing). Further, there are some good reasons to treat collective financing of activities like public education through taxes the same as collective financing of private activities like private schools through, in part, charitable gifts.

Maybe there are better solutions out there. But, whatever they are, they will in the end involve action from Congress, and solutions should aim to treat close substitutes the same. The mess we now face on SALT is Congress’s doing.