U.S. Department of the Treasury Internal Revenue Service (IRS) 1040 Individual Income Tax forms. (Photographer: Michael Nagle/Bloomberg)

After Federal Overhaul, States Weigh Changes to Own Tax Codes

(Bloomberg) -- After Congress passed the most significant overhaul of the nation’s tax code in decades, lawmakers in high-tax states are preparing changes of their own. 

Their concern is the new limit on the amount of state and local taxes citizens can deduct on their federal filings will be capped at $10,000, an amount lower than the current average deduction in Connecticut, New Jersey, and New York, according to Moody’s Investors Service.

Lawmakers say the new rule could depress home values as residents choose to live elsewhere, thereby making it harder for local governments to raise much-needed revenues of their own. Finances in the tri-state area are already among the most strained in the nation and analysts say the situation could deteriorate further under the new code.

Rather than wait and take the hit, some local lawmakers are taking action. In New Jersey, which has the highest property tax rates in the country, proposals are already under way to mitigate the impact of the Republican overhaul.

"Why would we look at the speck in Washington’s eye and ignore the boulder in our own?" New Jersey state Senator Joe Pennacchio said in a telephone interview.

‘It Takes Something Shocking’

Pennacchio, a Republican, introduced a bill on Dec. 7 that would abolish New Jersey’s $10,000 property tax deduction limit. The Garden State is not the only place where lawmakers are weighing changes to their tax regimes.

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In Vermont, more than 10 percent of residents’ incomes goes toward state and local taxes, according to a 2017 report by the Tax Foundation. State legislator Anthony Pollina, a Democrat who serves in the Vermont Senate, said the federal cuts will force the state to examine its own code.

He worries the federal bill will hit lower- and middle-income taxpayers hardest and wants to be sure the state’s rules are fair. Vermont could consider an income tax surcharge on wealthier residents who will see their federal tax burden lowered, Pollina said. That could help the state, which typically starts the year off with deficits, capture some of the tax savings they’ll see, according to the lawmaker.

"It’s been very difficult to have a serious discussion about tax reform and the need to raise additional revenue in the state," Pollina said. "Sometimes it takes something shocking like what we’re talking about with this new tax bill to force state legislatures to take action."

‘Please Send Your Ideas’

While the limit to the deduction won’t directly hit state governments’ coffers, it could have an indirect impact, such as increasing anti-tax sentiment as residents see their state and local tax burdens rise, Moody’s said in a report Thursday. The change to the mortgage interest deduction is also likely to slow home construction and sales, which could suppress home values and property tax values in higher-price markets, according to the credit rating company.

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Legislators say states could replace the income tax with payroll tax that are levied on employers. They could also turn their state taxes into charitable donations, in which residents could receive a state income-tax credit for the full amount of their gift and qualify for a federal deduction.

Liz Krueger, ranking Democrat of the New York Senate’s Finance Committee, said she was exploring potential changes to the state tax code, including replacing the state income tax with a payroll tax paid by employers.

“I’m certainly exploring workarounds and ways to rethink our current state and local tax model to see whether we can decrease harm to the state of New York," Krueger said. “Please send your ideas to Liz Krueger."

If employers pay the payroll tax and reduce employees’ salaries by the same amount, workers wouldn’t have to deduct anything and would wind up being paid the same amount. That would allow states to collect the same revenue while preserving individuals’ deductions on federal returns.

States with progressive income-tax rates would need to devise a system of tax credits to make payroll taxes hit the right rates, said Daniel Hemel, an assistant professor at the University of Chicago Law School, who floated the idea earlier this month. Union contracts guaranteeing certain wage levels could be a challenge, as would explaining salary cuts to workers.

Switch To Payroll Tax

Virginia Lyons, a Democrat who serves on Vermont’s Senate Finance Committee, said the state could consider allowing residents to make charitable gifts to the state instead of paying income taxes and could also consider a switch to the payroll tax.

The first thing the Senate Finance Committee will do once in session is consider the impact of the federal tax overhaul on Vermont, Lyons said. The conversion to the payroll tax would be "more of a heavy lift" for Vermont, while the charitable gift change is less onerous and could happen as soon as 2018, she said.

Lyons said it will take time to consider changes and she wants to make sure the state does not penalize middle-class residents.

"There are so many things in the tax bill that offer concern for us," she said. "It’s put greed in politics over people, which is really unfortunate."

©2017 Bloomberg L.P.

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