The Problems with State Workarounds to the Federal SALT Deduction

Weeks after Congress passed a federal tax overhaul, states most adversely affected by the $10,000 cap on state and local tax deductions (SALT) have been weighing schemes to ensure their residents continue to receive a break on taxes paid that exceed the new cap.

On its face, it may appear reasonable for lawmakers to make sure their constituents don’t face a tax increase due to a federal tax law that was duplicitously billed as an across-the-board tax cut that would mostly benefit working people. But it’s important to keep in mind that most taxpayers affected by SALT will still receive significant tax cuts under the federal bill. And, a deeper examination of some policies that state lawmakers are proposing to “work around” the federal tax bill reveals that not only would states compound adequacy and equity problems the federal law created in the first place, they would also make it more difficult to raise revenue at the state level to fund critical priorities.

From the outset, states—particularly wealthier states—objected to the GOP’s proposal to limit SALT deductions in part because it reduces the amount of state and local taxes that the federal government essentially picks up for taxpayers (by allowing a SALT deduction, the federal government is, in effect, paying part of taxpayers’ state and local tax bill), which could hinder states’ ability to raise revenue. Simply focusing on SALT, though, misses the bigger picture. The fact remains that the overall tax bill disproportionately benefits higher-income taxpayers even with the $10,000 SALT cap in place. Responding to federal tax cuts that disproportionately benefit the rich with state proposals that help bestow more tax cuts on upper-income taxpayers is irrational.

Complicated schemes such as replacing income taxes with payroll taxes or making state and local taxes a charitable contribution are bad policy. Schemes states are considering include replacing state income taxes with payroll taxes or converting state and local taxes into charitable contributions so taxpayers can write down that expense on their federal taxes. Both ideas would create more problems than they would solve.

Under the new tax law, employers can still fully deduct payroll taxes they pay on behalf of their employees. So lawmakers are trying to determine how they can convert state income taxes into a payroll tax. In theory, employers would reduce compensation to offset the cost of the payroll tax and workers would be unharmed because they would no longer have to pay state income tax. But what would prevent employers from reducing pay for workers with the least bargaining power—who have lower pay and benefits to begin with—and leave pay unchanged for high-earners? Another issue is this proposal doesn’t consider that some income isn’t subject to a payroll tax. For example, investment income that mostly flows to the richest households, such as capital gains and stock dividends, are subject to state income taxes, and it’s not clear how they would be taxed in a state that shifts to a payroll tax in lieu of an income tax.

Furthermore, most states provide an earned income tax credit (EITC) that is extremely important in fighting poverty among people who work and pay various other types of taxes but earn too little to owe income taxes. It’s not clear how such tax credits could be implemented in a state that shifts to a payroll tax. It is almost certain that a shift to payroll taxes will create a whole new set of winners and losers in states that currently have fairly progressive income tax structures.

Other states are considering proposals that would provide taxpayers with a credit for “charitable contributions” made to state and/or local governments in lieu of a state income tax. A taxpayer’s total payments would be unchanged because their state taxes would be reduced by the amount they contributed. But taxpayers would, the argument goes, be allowed to fully deduct the amount on their federal tax returns because the federal tax bill does not significantly change rules allowing charitable giving to be deducted for federal tax purposes.

But the IRS could—and should—block this approach because it violates the basic rationale for charitable deductions, which is that money given by a taxpayer to charity does not benefit the taxpayer but society generally.

The bottom line is that the federal tax bill redistributes wealth to the already wealthy (a fact of which the broader public is well aware). State tax systems are already regressive, meaning they capture more income from lower-income people than from the rich. The new federal tax law has ample problems that can only be addressed with fundamental changes or full repeal. Since this is not likely to happen in the foreseeable future, the most logical response by state governments is to shore up education and other public investments by increasing state taxes on high-income households and corporations that received massive tax breaks. New Jersey, for example, is weighing a proposal to raise taxes on the state’s millionaires.

This is a better approach. Trying to fix what Congress broke and focusing on helping upper-income taxpayers who, overall, are reaping the greatest benefit from the tax bill will result in ill-conceived policies.

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