In any maddeningly complex system, there are always holes to be found and loopholes to be exploited. And despite its many merits, the recently-passed tax overhaul bill is no exception.
As the ink dries on President Trump’s signature, tax lawyers, accountants, and even academics are on a quest to discover unforeseen issues with the new law that could complicate tax relief and erode the revenue raisers that were passed within it.
Chief amongst these issues is the state and local deduction (SALT), which Congress boldly capped at $10,000 regardless of the mix of taxes chosen. Where applicable, tax accountants are advising clients to prepay state and local taxes by the end of 2017 (the clock is ticking) in order to receive the tax write off. A team of prominent legal scholars recently analyzed a long-term “fix,” in which states can successfully circumvent the cap via the charitable deduction, which remains untouched by Congress.
Since the Internal Revenue Service allows taxpayers to make federally deductible donations to a number of “charity funds” supported by state taxes (ie. university funds), states can get back a good deal of funds lost to the SALT cap. In addressing these state government tricks, federal lawmakers and the IRS must tread carefully. If Congress allows local players to completely sidestep new deduction limits, new taxes will take away from taxpayers’ hard-fought gains.
For decades, the SALT has allowed (mainly) high-income earners a way to reduce their federal tax by deducting state and local levies off of taxable income. States and localities found that, unsurprisingly, hiking taxes is far easier when many of the largest taxpayers feel insulated from the increase. While Uncle Sam took a hit from the reduced federal tax revenue, lawmakers close to home raked in billions of dollars with hardly a protest from targeted high-earners.
But starting in 2018, hiking state and local taxes will get a whole lot harder. Already, New Jersey Gov.-elect Phil Murphy’s promised 4 percent millionaire surtax is entering rough waters. New Jersey Senate President Stephen Sweeney, once a staunch supporter of the proposal, said he’ll need to reassess this proposal due to the looming SALT cap.
Blue states looking to tax their millionaires may resort to advertising the charitable deduction for state-funded services. Legislators in Sacramento are already hashing out a plan to allow taxpayers to donate to the state and to their respective localities via a charitable trust, in exchange for a tax credit from their jurisdiction. And, since the IRS and federal courts have previously given their blessing to this sort of “tax laundering,” lawmakers across the country are sure to give this trick a try.
In the broadest sense, these games undermine the revenue raising provisions put in place by Congress to “pay for” across-the-board tax relief. Assuming that “charitable conversions” are successful and high-end taxpayers are privy to these loopholes, federal payers will continue to be bilked for local hikes.
But Congress may inadvertently quash a new experiment in governance if it goes too far in clamping down on these state and local efforts. If charitable deductions are allowed for specific programs, taxpayers can be emboldened to choose the line items they deem worthy of funding. Such a system would be far preferable to the current norm of general fund taxation, whereby lawmakers expect voters to trust them (for the time being) in funneling money to wherever it is appropriate.
For example, New Jersey taxpayers were told their hard-earned money would bolster poor school districts, but instead, the revenue fueled cronyism without improving outcomes. But charitable deductions to public entities are usually slated for narrow targets that the individual taxpayer can choose. Instead of relying on politicians’ dubious promises election after election, taxpayers would choose which programs are worthy of continued funding on their own.
Congress can bolster this “tax choice” by giving municipalities the green light to treat specific programs as charitable funds. At the same time, federal lawmakers must bar their local counterparts from allowing charitable deductions for general funding. This powerful one-two punch will make line items more dependent on taxpayer approval, and reduce the role of special interests in siphoning off public funds.
As with many other tax reform provisions, the SALT cap has been blown out of proportion by critics. Incentives driving state taxation and spending are deep-seated, and will take many years to shift. But as changing tax tectonics slowly but surely work their magic, local lawmakers will turn to Washington to clarify rules. By carefully tailoring “loopholes,” Congress can ensure that complexity gives way to tax choice across the country.
Ross Marchand is the director of Policy for the Taxpayers Protection Alliance.
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