Before the so-called “Big Six” even released their tax reform plan, special interests were clamoring to save their favorite tax preferences. One of the most significant is the state and local tax (SALT) deduction, a tax break that subsidizes high-income earners in high-tax states.
Based on preliminary details, policymakers will need to offset about $5 trillion in reductions over a 10-year budget window. There are a number of targeted tax breaks that lawmakers could eliminate to make the math work, but the deduction for state and local taxes may prove key to getting tax reform done.
Under current law, taxpayers who itemize (only 30 percent do) are permitted to deduct from their federal taxable income many of the taxes they pay to state and local governments. The deduction, which will cost the treasury an estimated $1.8 trillion over the next decade, chiefly benefits wealthier taxpayers in high-tax states such as New York, California, and New Jersey. About 88 percent of the tax break’s value accrued to those with incomes in excess of $100,000 in 2014, and only 1 percent flowed to taxpayers with incomes below $50,000.
Although the federal tax code is progressive overall, the SALT deduction is a glaring exception, subsidizing higher-income, higher-tax jurisdictions at the expense of lower-income regions. It is one thing for a wealthy community to embrace costly public amenities, and quite another to expect the rest of us to subsidize them. Nevertheless, entrenched interests defending the deduction are standing in the way of fundamental tax reform.
All levels of government must strike a balance between demand for government-provided services and the desire to keep taxes and spending in check. The residents of some localities are willing to accept higher levels of taxation in exchange for greater government service provision; others prefer a smaller government which necessitates lower rates of taxation.
Taxpayers may be supportive of higher spending levels than they would otherwise favor if part of the cost is borne by others. Federal subsidies thus place a thumb on the scale, distorting local decision-making and forcing those in lower-amenity (and frequently lower-income) jurisdictions to subsidize wealthy, high-tax areas.
Taxpayers in all states take advantage of the deduction, but it represents an outflow from most states and localities into a favored few — in large part because they choose bigger government and are rewarded for it.
It has been more than 30 years since the last round of federal tax reform, which has emerged as a top political priority in 2017. Members of Congress and the Trump administration have advanced a set of priorities for tax reform that include improvements to the tax code’s economic efficiency by reducing rates and broadening the tax base, along with measures to reduce the code’s complexity. Repealing the SALT deduction advances both of these goals while helping to pay down a substantial reduction in marginal rates.
Unfortunately, special interests have rallied to the state and local tax deduction. Some municipal governments, eager to save a provision which allows them to export some of their tax burden, have teamed up with businesses that benefit from the deduction’s existence, launching a campaign called “Americans Against Double Taxation,” deploying flawed logic to justify keeping this deduction.
Whereas other arguments for saving the deduction tend to come from the political Left, the double taxation concern just as often comes from, or is intended to appeal to, the Right, predicated on the belief that without the deduction taxpayers will be paying tax on a tax.
If that were true, it would be a compelling argument in favor of the deduction. However, it’s not. In our federalist system, each level of government provides its own package of services, which one would expect to be “priced” separately. No one argues that we should be able to deduct our local sales taxes from our state sales tax, or back out the state gas tax from the federal gas tax.
States and localities with high tax burdens wish to continue to receive subsidies from the rest of the country. Some in favor of larger government see it as a way to encourage state and local governments to spend more by diffusing costs and concentrating benefits.
That works great—until everybody does it.
Compared to most of the tax reform options on the table, retaining the SALT deduction offers limited economic benefit, with Tax Foundation estimates pegging the adverse economic impact of repeal at a modest 0.4 percent reduction in GDP over a decade. This would be offset many times over if used as a key pay-for in pro-growth tax reform.
For the first time in years, meaningful tax reform is a serious possibility, but Congress must make the numbers work. Repealing the SALT deduction is an important piece of the puzzle.
Jared Walczak (@JaredWalczak) is a senior policy analyst at the Tax Foundation in Washington, D.C.
If you would like to write an op-ed for the Washington Examiner, please read our guidelines on submissions here.
