New Jersey’s incoming Democratic Gov. Phil Murphy was aiming to impose a millionaires’ tax to boost state spending. But top statehouse Democrats balked as they saw the Republican tax plan advancing in Congress.
In rewriting the compact between Washington and lower levels of government, most notably by significantly limiting the state and local tax deduction, the GOP tax plan would make such state tax hikes much more painful.
The tax overhaul would raise the taxes of some earners and make it harder for states to do the same. The ultimate effect would be to decrease governments’ ability to raise taxes and increase spending – essentially reining in state budgeteers.
That is an advantage to conservatives who have long sought to advance fiscal conservatism at the state level and who see the state and local tax deduction as a subsidy for high-spending, high-taxing states – that is, blue states.
“This was our point from the start,” said Jonathan Williams, chief economist at the American Legislative Exchange Council, a group that advocates free-market policies for state governments.
“We hope that it engenders more fiscal discipline at the state level in those high-tax states,” Williams said.
The deduction has long been a target, as former President Ronald Reagan also sought to eliminate it. And now, the state and local tax deduction is in real trouble. Under current law, taxpayers can use it to subtract state and local property taxes and income or sales taxes from their federal taxable income. Under both versions of the Republican bill, that would be limited to just $10,000 on property taxes, although the final legislation could broaden the break.
The deduction has been part of the Internal Revenue Code since the beginning. What has changed is that there are no longer Republican senators from high-tax, high-spending blue states to defend it. “The increasing partisan polarization at the national level was one of the conditions that made this possible,” said Michael Greve, a professor at the Antonin Scalia Law School at George Mason University who has studied the U.S. system of federalism and favors limiting the deduction.
President Trump's administration has gone directly at the break as a subsidy for lower-government fiscal irresponsibility. Asked for comment, the White House Council of Economic Advisers pointed to studies finding that states rely more on deductible taxes, rather than business taxes or fees, thereby shunting their costs onto Uncle Sam.
The prospect of Trump succeeding and the bill passing has some blue-state Democratic executives employing apocalyptic rhetoric.
New York Gov. Andrew Cuomo, for instance, has compared House Republican lawmakers who voted for the bill to the infamous traitor Benedict Arnold and, in a recent call with editorial writers, said the tax bill was an attempt to "rape and pillage” New Yorkers.
Rhetoric aside, Cuomo and other states have reason to worry. Over time, the limitation on state and local tax deductions would turn many blue states into credit risks by diminishing their control over taxation, said Laura Porter, head of the states rating group at Fitch Ratings.
“The clearest thing is that it seems like it would make it harder for states, those states, to raise taxes,” she said.
Here’s why. By limiting the deductibility of state and local taxes, the GOP tax plan would result in tax increases on some moderate- to high-income people in blue states.
In the first few years, most taxpayers would get tax cuts or be held harmless, thanks to the lower rates, doubled standard deduction, and expanded child tax credits. But taxpayers paying lots of property taxes and itemizing other deductions, such as mortgage interest and charitable contributions, could see tax increases. About a third of the top fifth of income earners in New York state, for instance, would see net tax increases, according to the Institute on Taxation and Economic Policy, a left-of-center think tank.
Once those residents got hit by the higher taxes, it would be difficult for state governments to tax them more.
That’s a problem, said Manhattan Institute budget expert Steven Malanga, because many state governments are already struggling to meet their obligations. “This clearly makes it more difficult for states to raise taxes because these folks who they are most likely to raise taxes on to solve budget problems, meaning rich people, are already going to be taking a very big hit,” because of the limitation on state and local tax deductions, he said.
In bearing the full cost of state and local taxes, Malanga said, wealthy taxpayers may decide to simply leave for lower-tax locales. He cited the example of the hedge fund manager Jonathan Tepper, who left New Jersey in 2016 for income-tax-free Florida, costing New Jersey likely hundreds of millions of dollars and singlehandedly threatening the state’s budget. The GOP plan would significantly increase the tax differentials between states.
There is mixed evidence about how much state tax differentials can influence residents to leave. Carl Davis, the research director for the Institute on Taxation and Economic Policy, called the phenomenon of tax-driven moves “overblown,” citing a 2016 study by economists at Stanford University and the Treasury that found minimal millionaire “tax flight.”
Republican members of Congress who back the tax plan, though, have argued that best course of action for state governments would be for them to follow the federal government’s lead and cut their own taxes to prevent residents from fleeing.
“The problem isn’t the deduction on federal taxes,” Rep. Tom Reed, representative for an upstate New York district, wrote in a response to Cuomo. “The problem is the crushing burden of New York state taxes.”
That is an outrageous solution from the liberal point of view. Right after Congress cuts taxes for the 1 percent, “the last thing states should do is pile onto that problem with more tax cuts for the rich,” Davis said.
Also, most states just aren’t in a position to cut taxes, said Fitch Ratings’ Porter, given that they are still struggling to shore up their budgets in the wake of the recession. “We don’t think it’s a reasonable expectation that states would be lowering taxes in response” to the tax bill, she said.
Instead, states are in a bind and will soon face pressures to scale back spending on services.
Especially since they are soon likely to also face a significant drop in federal funding, thanks to reductions in Medicaid and other programs, Porter noted.
The deduction “is just one in a whole suite of issues that we think are going to fundamentally change state and local relationships,” said Matthew Chase, executive director of the National Association of Counties.
Today, states with many rich inhabitants, such as New York, subsidize states with lots of poor residents, like Mississippi, paying more into the Treasury in taxes than they get back in Medicaid, food stamps and other programs.
“The entire fiscal arrangement that we’ve had was built on sort of a rough consensus that wealthy states would subsidize less prosperous ones,” Greve said.
If Republicans in Congress follow through by raising blue states’ taxes while sending them fewer dollars for welfare programs, those inequalities will worsen. For blue states, he said, “this has always been a sucker’s deal.”