The SALT Deduction Isn’t Just a Subsidy to High-Tax Blue States

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Seven Democratic governors sent an interesting letter to President Biden on April 1, topped with seven colorful circles representing the seals of California, Connecticut, Hawaii, Illinois, New Jersey, New York, and Oregon. Interesting because while Democrats see themselves as defenders of the poor, their letter was seeking a change in the federal tax code that would—at least at first—primarily benefit their richest constituents.

The letter asks Biden to roll back a provision of President Trump’s Tax Cuts and Jobs Act of 2017. The provision puts a $10,000 limit on the amount of state and local taxes that Americans can deduct from their income for purposes of calculating their federal tax liability. People who pay more than $10,000 in state and local taxes tend to be pretty well-off—and to live in states that have high tax rates, which by and large vote blue.

So the letter-writing Democratic governors face opposition to their rollback request on two fronts: from Republicans who oppose what they call a giveaway to Democratic-voting states and from liberal Democrats who oppose what they call a giveaway to the wealthy. 

The optics are bad. But the deduction for state and local taxes (SALT) actually serves a purpose. That’s why it’s been law since the first federal income tax under President Abraham Lincoln. The problem the SALT deduction combats—imperfectly—is tax competition, which is a destructive race to the bottom in taxes and government services.

A state that slashes tax rates and balances its budget by simultaneously reducing services to the poor wins two ways: It gets an influx of businesses and residents from higher-tax states, and it chases away poor people, who make their way to those high-tax states that are losing their tax base. It’s an unsustainable dynamic. The SALT deduction restrains tax competition by subsidizing high-tax states: the pinch that taxpayers in those states feel from high state and local taxes is eased by the break they get on their federal returns.

Republicans and voters in low-tax states (overlapping groups) sometimes ask why the federal government should be subsidizing states that choose to impose high taxes. Fair question. One reason is that some of the benefits of high-tax states’ higher spending are shared by people in low-tax states. The safety net for the poor. The roads and other public infrastructure that are available to residents and visitors alike. It’s also worth pointing out that when you add up all the flows, high-tax states on average contribute more to federal coffers than they get in return.

A bit of tax competition can restrain state and local governments from overpaying their employees, wasting money on boondoggle projects, and so on. But high-tax states, while hardly models of efficiency, have been tightening their belts for years. There’s only so much more they can cut given their aging infrastructure, the legacy of overly generous pensions, and populations that are costly to serve. 

It’s true that restoring full deductibility of state and local taxes would reduce federal tax revenue a lot. That’s why the Biden administration is cool to the idea. “If Democrats want to propose a way to eliminate SALT [caps]—which is not a revenue raiser, as you know, it would cost more money—and they want to propose a way to pay for it, and they want to put that forward, we’re happy to hear their ideas,” White House Press Secretary Jen Psaki said on April 1.

It’s also true that most of the benefits would go to high earners. But that’s not necessarily a permanent condition. Think about this problem dynamically, not statically: State governments constantly weigh how much they can tax their richest residents without driving them away. Since the passage of the Tax Cuts and Jobs Act at the end of 2017, the effective state and local tax burden on rich people in blue states has gone up. And predictably, some rich people are bailing out, as Richard Florida of the University of Toronto explains in a column for Bloomberg CityLab. (Congress wisely left the full deduction in place for corporate income taxes because corporations are more mobile than individuals.)

If the SALT deduction cap remains in place, state governments are going to be forced to stanch the bleeding by cutting taxes on their rich residents. In other words, rich people can move; they will be OK whether the cap stays or goes. Restoration of full SALT deductibility isn’t for their sake and wouldn’t make much difference to them in the long run. It’s the high-tax states like New York and California that need help. The Democratic governors write that Trump’s change in the tax code “was based on politics, not logic or good government.”

There was a good article on this in 2019 in the San Diego Law Review by William Barker, a professor at Penn State Dickinson Law, a law school of Pennsylvania State University in Carlisle. It’s wrong, he writes, for people to be taxed on the federal level for money they no longer have, because it was taxed away at the state or local level. “This adverse consequence of double taxation between federal and state tax systems in a federal system has not received proper attention. Mitigating double taxation has been a fundamental building block of both the international and interstate tax order.” Barker argues that Congress should go beyond restoring full deductibility of state and local taxes from their taxable income. It should give taxpayers an outright credit on their federal taxes for whatever they paid in state and local taxes—limited to some percentage of their total federal tax liability.

©2021 Bloomberg L.P.

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