Some Solutions for State and Local Tax Deductibility

By Girard Miller
Governing
(TNS)

To help pay for middle-class tax cuts in 2017, Congress put a $10,000 limit on itemized deductions for state and local taxes, known as the “SALT” deduction. Although only some 10 percent of federal income tax returns included itemized deductions last year, fewer yet exceed the SALT ceiling—mostly a subset of taxpayers with six-figure incomes.

Yet when it was enacted, this move prompted more vocal complaints than almost any other tax law provision. Its impact is felt mostly by homeowners in jurisdictions where a combination of above-average state income taxes and hefty local property taxes puts them over the deduction limit.

Along with other provisions of the 2017 tax law, the SALT cap is set to expire next year, guaranteeing that it will become a political football. Even though this is a non-issue to 90 percent of the tax-paying population, it’s a heated topic along partisan lines, with anti-tax conservatives claiming that an uncapped SALT deduction rewards spendthrift state and local politicians while others argue that the cap penalizes too many middle-class households. Public officials in the most affected states and localities have a clear interest in finding a way to provide some extra tax relief to households that pay out more than the $10,000 deduction limit. The problem is how to pay for it.

The expiration of the 2017 tax cuts will have disparate impact, as a recent Wall Street Journal article illustrates vividly in a county-by-county map showing winners and losers from some of the many provisions reverting to prior rules. That thrusts state and local officials, their national associations and their Washington representatives smack into the middle of next year’s tax debates—what has been called the Super Bowl of taxes. It will be an uphill battle to get an explicit increase in the SALT limit. That means it’s time for the state/local community to find savvy ways to work its agenda into the changing landscape of the federal tax system while addressing complaints from both ends of the political spectrum along with centrist deficit hawks’ intensifying hand-wringing.

Possible revenue-neutral approaches would be to cap all deductions—including medical expenses and charitable contributions—at something in the ballpark of $70,000 or to reinstate the pre-2017 graduated phaseout on how much taxpayers at the top 5 percent income level could claim in itemized deductions (known as the Pease limitation for its congressional author). Those limitations would be more friendly to the middle class at the expense of the affluent. Otherwise, the default budget alternative will be higher marginal tax rates for everybody with six-figure incomes, which will cut right into a lot of middle-class voters’ pocketbooks.

The only obvious additional alternative for funding a higher SALT cap that’s entirely within the attention span of state and local governments would be to forego the tax exemption on private activity municipal bonds, which would offset some $35 billion of the cost of a higher SALT deduction limit over 10 years, according to the Congressional Budget Office. That would amount to maybe a third of the cost of doubling the current SALT cap, based on various budget projection models.

But it’s hard to imagine that the public finance community would rather give up the politically popular economic leverage of private activity bonds just to benefit a subset of upper-middle-class households. Which brings us back to choosing among designing a combined deduction cap of some kind, an itemized-deduction phaseout, keeping today’s SALT limit or finding fiscal black magic in the Capitol basement where imaginary economics so often lurk.

My suspicion is that if Congress forced them to choose, most state and local government representatives on Capitol Hill would opt for either an overall cap on all deductions or an updated form of the Pease phaseout formula. It gives them an immediate answer for the how-to-pay-for-it question while also dodging a specific limit on the SALT deduction or making unpalatable tradeoffs affecting the muni bond market.

Grouchy billionaires

On the stratospheric end of the income spectrum, there is perennial grouching from the billionaire class, where vocal fat cats complain that their combined federal, state and local tax bills eat up more than half their income. Although that is rarely true in practice because the federal tax laws provide preferentially lower rates on investment income, the upper crust still makes a lot of noise about “confiscatory” taxes at the state and local level when added to the top federal bracket. It’s a common rationale given for relocating to low-tax states.

The fact is that less than 1 percent of federal taxpayers pay even a portion of income tax at the top rate. There are presently four states with top state and local income tax rates of 10 percent or more; in California and New York City, the top combined rates are in the lower teens. The intersection of those Venn diagrams is a population of about a quarter of 1 percent of American households. Because marginal rates are not effective rates, it’s nearly impossible for many of them to actually pay more than half of their total income in combined federal, state and local income taxes. And for historical perspective, under Eisenhower, Nixon and Ford the top federal bracket—not even taking into account state and local taxes—was 70 percent.

With that in mind, a case can be made for a “total tax circuit-breaker” for wealthy taxpayers whose income tax payments for all levels of government exceed the top combined rates in other developed countries. That works out to 45 percent or a bit less, and would arguably rebut the “confiscation” argument, at least in comparative terms. Also, bear in mind that there is no other country in the world where wealthy investors can collect tax-free interest from political subdivisions, which further reduces their effective and comparative tax rates.

Legislative strategies

A reasonable, comprehensive total-tax circuit-breaker for the super-rich will surely irk some progressive politicos on the far left, but governors and mayors in higher-tax jurisdictions will quickly see the merits of this formulation. It undercuts the incentive for prosperous Californians and New Yorkers to relocate their tax residency to states like Florida, Nevada and Texas that have no income tax.

And by applying to taxable income of all kinds without any tax preferences, the revenue cost to Uncle Sam for this circuit-breaker credit would be minuscule relative to the proceeds of re-instituting the upper-tier 2016 tax rates or any other serious tax reforms that Congress may consider next year. Policy wonks can debate either way as to whether or which kind of muni bond interest should then be included in this exceptional and rarified calculation. For example, should income from private activity muni bonds that are subject to the alternative minimum tax be included or excluded from these formulas?

To win bipartisan approval, such a proposal would almost certainly need to allow residents of states with no or low income taxes to substitute their sales tax or homestead property tax payments in the credit calculation. In most cases, those regressive “consumption” taxes won’t tally enough to trigger a fat cat’s comprehensive 45 percent circuit-breaker very often, but such a provision would muffle some of the predictable demands for “tax parity” on Capitol Hill.

By working under the radar, these state-and-local provisions could still survive the messy politics of next year’s congressional tax bills, if promoted persistently in the right places on Capitol Hill—especially to the House Ways and Means committee and staff.

As November elections near, it’s unlikely that campaign ads or policy debates with this much granularity will occur, because retail politics are played in broad generalizations and rarely in such specifics. But some of these tax reforms could be summarized in simple terms easy for lawmakers to understand. There’s not a member of Congress who hasn’t heard about the SALT issue. Meanwhile state and local policy associations and staffers can work on Capitol Hill to promote key concepts that fit under the broad umbrella of intergovernmental tax equity.

Governing’s opinion columns reflect the views of their authors and not necessarily those of Governing’s editors or management.

ABOUT THE AUTHOR:

Girard Miller is the finance columnist for Governing. He is a retired investment and public finance professional and the author of “Enlightened Public Finance” (2019). Miller brings 30 years of experience in public finance and investments as a former Governmental Accounting Standards Board member and ICMA Retirement Corp. president.

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