Why States Should Seek to Offset the Effects of the SALT Rollback
A response to a thoughtful but critical Tax Policy Center analysis
I usually find myself in agreement with Tax Policy Center experts Leonard Burman and Frank Sammartino, and I almost always learn a lot from reading their analysis. But I disagree in almost every respect with their recent post on proposals in several states to use payroll taxes and charitable credits to offset the impact of the new federal tax law’s SALT limitations.
Burman and Sammartino argue that the new $10,000 cap on the state and local tax (SALT) deduction is “one progressive element” of an otherwise regressive tax law. They say that there is “little empirical evidence” that the $10,000 cap will affect the ability of states to raise revenue for social welfare programs, and they worry about “unintended consequences” for taxpayers who benefit from the earned income tax credit (EITC) and the child tax credit. They also worry that responses from states could lead Congress to impose further limits on SALT.
I have argued here and elsewhere that states should respond to the new federal tax law by shifting away from personal income taxes on wage income and toward employer-side payroll taxes. (I provide further details on how this shift might work in a short piece published by Bloomberg Tax last month.) The core of the case for a payroll tax shift is that all workers — and not just those who itemize deductions on their federal income tax returns — should be able to pay with federally deductible dollars for public schools, public hospitals, public infrastructure, and other public services provided by state and local governments. This is especially true in a tax system that now allows an immediate deduction for most business capital expenditures and that still allows an itemized deduction for charitable contributions. The new federal tax law puts the civic sector at a disadvantage vis-à-vis the private and nonprofit sectors — for no apparent reason except that blue state voters choose to invest more in civic institutions. In my view, states such as New York can and should restructure their tax systems in order to preserve and expand their residents’ ability to fund state and local government with deductible dollars. I think Governor Cuomo deserves kudos for taking the lead on this.
In their critique of these efforts, Burman and Sammartino begin by reminding readers that “the vast majority of people, even in high tax states, will pay lower taxes under the new law until the individual income tax cuts expire in 2025.” That in itself is debatable: the Join Committee on Taxation’s distributional estimates (which, unlike the Tax Policy Center’s estimates, reflect the repeal of the individual mandate and the follow-on effect on premium tax credits) indicate that the new law will lead to an increase in average net tax liability for families earning less than $40,000 even before the individual cuts expire. But it’s also beside the point. The new tax law certainly does increase the after-tax price of public goods and services supplied by state and local governments — at least for households in the top quintile of the income distribution, who pay well over half of all state and local taxes. And generally, a rise in the after-tax price of goods and services leads people to purchase less of them.
Burman and Sammartino are correct that the SALT deduction is claimed primarily by high-income households. But because a shift toward a state-level payroll tax would benefit non-itemizers as well as itemizers, the immediate effects of a payroll tax shift are more progressive than the old SALT deduction. Moreover, and perhaps more importantly, legal incidence does not equal economic incidence. The benefits of SALT likely flow not only to the taxpayers who claim the deduction but also to the individuals who rely on state and local governments for education, health care, housing, cash assistance, and so on — and who will thus will be harmed if state and local spending drops.
It is true that the econometric literature regarding the SALT deduction’s effects on state and local revenue and spending reaches mixed results. But I think Burman and Sammartino overstate the case when they say “there is little empirical evidence that federal income tax deductibility directly impacts peoples’ willingness to pay higher state taxes.” The hypothesis that the SALT deduction leads to more state and local spending is extraordinarily difficult to test in light of the lack of crisp natural experiments and the multiplicity of confounding factors. Nonetheless, several peer-reviewed papers by highly regarded economists and tax law scholars do identify such a relationship, including this 1990 study by Douglas Holtz-Eakin and Harvey Rosen (focusing on local property taxes), this 2011 article by Gilbert Metcalf, and this 2014 article by co-blogger Brian Galle. Several more studies find that the SALT deduction affects the mix of subnational revenue sources (see, for example, this 2003 article by Oded Izraeli and Mitchell Kellman, as well as this 2015 article by Bradley Heim and Yulianti Abbas, both of which find state-level effects). That, in turn, suggests that (1) state tax policy is responsive to federal deductibility and (2) federal deductibility for state income taxes leads states to rely more on those taxes — which are generally more progressive — and less on regressive sales taxes. [Update: I should add to this list an important 2005 National Tax Journal article by Howard Chernick, which finds a strong relationship between the percentage of itemizers and the net progressivity of a state’s tax system. Chernick concludes that “[t]he magnitude of the effect implies that eliminating or curtailing the deductibility of state and local taxes would substantially reduce the progressivity of subnational tax systems.”]
Burman and Sammartino go on to warn that “[a]bsent very careful design, the payroll tax option could have unintended consequences.” They elaborate:
For example, the employer payroll tax could lower wages by the amount of the tax, keeping total compensation constant. But lowering wages would reduce federal tax benefits such as the EITC and the child tax credit for some households. The excellent New York state report addresses these and other issues and proposes plausible solutions, but they come at the cost of significant additional complexity.
I agree that the New York report referenced by Burman and Sammartino — from the state’s Department of Taxation and Finance to Governor Cuomo — is indeed “excellent.” The solutions to the EITC and child tax credit concerns are not at all complicated, however. By exempting the first $22,000 or so in wages from the new payroll tax, New York could ensure that changes in wages that result from the payroll tax do not reduce anyone’s EITC and do not reduce the refundable portion of the child tax credit for a single-income household with two children. (New York could choose a higher threshold if it wanted to ensure that there would be no loss of the refundable child tax credit for single-income households with more than two kids.) This is not “significant additional complexity.” It’s an easily administrable zero bracket.
Moreover, the wage effects would increase the size of the federal EITC for households in the phase-out range (which extends up to earned income of $51,598 for a married couple with two children). Thus, low-income families potentially benefit from the payroll tax shift in four respects: (1) they benefit from increased state and local spending on schools, health care, and social services; (2) they benefit from increased reliance on wage- and income-based taxes, and reduced reliance on regressive sales taxes; (3) for those with positive federal taxable income (i.e., over $24,000 for a married couple), they benefit because the payroll tax shift reduces their federal tax income; and (4) for those who are in the EITC phase-out range, they benefit from a larger federal EITC.
Finally, Burman and Sammartino are correct that Congress could — in theory — respond by changing federal law. I’m skeptical, though, that such legislation could win a majority even in the Republican-controlled House, as Republican representatives from blue states would be unlikely to give their assent. (There are 28 Republican representatives from California, New Jersey, and New York alone.) Burman and Sammartino further warn that “[i]f Congress disallows charitable deductions that are offset by tax credits, several existing state programs also could be invalidated.” Many of those existing programs are, in effect, acts of First Amendment arbitrage, designed to immunize private and religious school voucher programs from Establishment Clause scrutiny. At least in my view, if the federal government allows states to use charitable credits to finance private and religious schools, then it should allow states to use charitable credits to finance public schools and other public goods and services too. If Congress decides to end the unequal treatment by disallowing credits for private and religious schools, then that doesn’t strike me as such a terrible outcome.
Proposals like the payroll tax shift contemplated by the Cuomo administration grow stronger when they are subjected to scrutiny by perceptive commentators like Burman and Sammartino. The more thought that tax experts devote to the topic, the more likely it will be that a workable plan emerges. Burman and Sammartino are right that these proposals “raise important questions about the interaction between federal and state taxes that policymakers at all levels need to address.” But I think the answers to those questions generally point toward the conclusion that the SALT rollback in the new federal tax law was ill considered, and that it is entirely appropriate for state and local officials to seek to counteract the federal tax law’s negative effects.