States and Localities Can Offset Federal Tax Law's Impact on Their Residents
Bloomberg Tax: Daily Tax Report (February 9, 2018)
3 Pages Posted: 25 Jan 2018 Last revised: 15 May 2018
Date Written: January 12, 2018
The federal tax overhaul signed into law by President Trump in December 2017 strikes a blow to households in high-tax states, with potentially negative ramifications for state and local government finances. First, the law imposes a new $10,000 cap on the deduction for state and local taxes (SALT)—well below the average amount claimed by residents of high-tax states such as New York, California, and New Jersey. Second, the legislation rolls the preexisting law’s personal exemptions into a much larger standard deduction, which will mean that most taxpayers who currently itemize their deductions will stop doing so and thus will lose any SALT benefit. Absent any response from states and localities, the net effect of the new tax law will be that the vast majority of households pay their state and local taxes with nondeductible dollars—which, in turn, will likely make it more difficult for states and municipalities to raise revenue for their schools, hospitals, police and fire departments, and other vital public services.
But state and local governments are not helpless in the face of the new SALT limits. One proposal, which the State of California and several towns in New Jersey are considering, would allow taxpayers to claim a state or local tax credit in exchange for donations to government-affiliated organizations. Because such donations are treated as charitable contributions rather than state and local tax payments for federal income tax purposes, these arrangements would allow taxpayers who hit the $10,000 SALT cap to satisfy their remaining state and local tax obligations with federally deductible dollars. A second proposal—which is the focus of this report—would involve state and local governments shifting from employee-side personal income taxes to employer-side payroll taxes, which remain fully deductible for federal tax purposes. This payroll tax shift would deliver benefits for workers in states with high income taxes regardless of whether those workers itemize deductions on their federal tax returns. Importantly, the two proposals are not mutually exclusive, and states and localities would be well advised to consider both.
Proposals for a payroll tax shift stand on solid legal ground. Moreover, the administrative challenges of such a shift would be relatively straightforward in flat-income-tax states such as Illinois and Massachusetts—and not insuperable in states with graduated income tax rate structures such as California, New Jersey, and New York. By fighting to preserve their residents’ ability to pay for public services with deductible dollars, states and municipalities can protect their revenue-raising capacity while prodding members of Congress to reconsider a tax law that was ill conceived from the outset.
Keywords: state and local taxes, SALT deduction, payroll tax, fiscal federalism
JEL Classification: K34, H71
Suggested Citation: Suggested Citation