Ill-Considered Tax Credit Regulation May Put the Squeeze on Charities, Taxpayers
The White House Office of Information and Regulatory Affairs (OIRA) has started reviewing a draft of a final Internal Revenue Service regulation that seeks to prevent taxpayers from avoiding the cap on state and local tax deductions (colloquially known as the “SALT cap.”) Unfortunately, the version of the regulation the IRS proposed last August would also impose collateral damage on legitimate charities and taxpayers who are below the SALT cap. The administration can remedy those problems if it uses the OIRA review process to enforce some basic principles that have guided executive branch regulatory development for four decades.
In April 2018, the Treasury Department and the Office of Information and Regulatory Affairs closed a loophole that previously gave tax regulations an exemption from Executive Order 12866, which governs analysis and review of executive branch regulations. As a result, significant IRS regulations must now be accompanied by economic analysis of their consequences and must be submitted to OIRA for a 45-day review period. The executive order specifies that executive branch agencies shall identify and assess the significance of the problem the regulation intends to address, tailor regulations to impose the least burden on society, and use the best available evidence in their analysis.
We will not know the content of the final regulation until OIRA’s review is completed and the regulation is published. But the version proposed last August prohibits a taxpayer from claiming a federal charitable deduction if the taxpayer received a state or local tax credit exceeding 15 percent of the value of the donation.
The regulation addresses a significant tax avoidance scheme that high-tax states like New York, New Jersey, and California sought to create after the 2017 tax reform imposed a cap of $5,000 ($10,000 for a married couple) on deductibility of state and local taxes, known as the “SALT cap.” These states want to give tax credits to taxpayers who make “donations” to fund state and local government programs. By calling the expenditure a donation, the states seek to transform tax payments that are non-deductible for taxpayers who are over the SALT cap into deductible charitable contributions.
The IRS rightly seeks to prevent this end-run around a key element of the 2017 tax reform. But it wrote the regulatory proposal so broadly that it would also eliminate federal deductibility for donations to genuine charitable causes, such as school choice scholarship programs funded by state tax credits. Indeed, most of the nearly 8,000 comments the IRS received give the impression that the rulemaking has now become a referendum on school choice.
Both sides of the school choice debate have ginned up letter-writing campaigns, as evidenced by the numerous form letters in the docket. One letter supporting the charitable deduction is an obvious cut-and-paste job that reads, “My school participates in the [STATE] tax credit scholarship program [NAME].” Numerous other identical letters from “a parent and a PTA member” urge the IRS to refrain “from creating a special tax carveout for donations to private schools.”
The IRS could have avoided this mess if it had hewed more closely to the regulatory analysis principles in Executive Order 12866. The IRS proposal names a potentially significant problem — state-sponsored schemes that let taxpayers avoid the SALT cap — but the agency failed to tailor the regulation to impose the least burden on society, for two reasons.
First, it hits taxpayers who are below the SALT cap by prohibiting deductibility of state or local taxes when the taxpayer received a state or local credit. The IRS’s own calculations show that the regulation would increase the cost of charitable giving for these taxpayers, compared to current regulations. The Treasury Department and IRS merely assert that they believe that few taxpayers in this group make contributions for which they receive state tax credits — an assertion accompanied by no evidence whatsoever! The executive order’s “best available evidence” standard requires more than assertion of a regulatory agency’s belief.
Second, the regulation eliminates deductibility for donations to legitimate charitable causes funded by tax credits that were not adopted as SALT avoidance strategies. Tax credits in place before the 2017 tax reform are one example. In the future, states may also create new tax credit programs that legitimately support charitable causes. The IRS could develop guidelines that distinguish legitimate charitable tax credits from SALT cap avoidance schemes, but this alternative is not discussed in the NPRM.
If the administration follows the spirit of the executive order the Treasury Department agreed to follow in April, the final regulation will be more carefully tailored to address states’ new SALT cap avoidance schemes.
Jerry Ellig is a research professor at The George Washington University Regulatory Studies Center. He has published extensively on the quality and use of economic analysis in federal regulatory agencies.