New Treasury Rule Subsidizes High-Tax States
It is no secret the federal tax code is unbalanced and unfair. A byzantine network of deductions and carveouts favor some, while the remaining taxpayers foot the bill. The Tax Cuts and Jobs Act of 2017 (TCJA) made federal taxation fairer by limiting the amount of money taxpayers could claim under the “state and local tax (SALT) deduction” to $10,000 annually. Now, the Treasury Department has worked against that accomplishment by enacting a new rule that exempts certain businesses from the SALT deduction limit. While lowering tax burdens for businesses is generally good policy, policymakers should seek to lower rates rather than tweaking complicated deductions. Not only is the new Treasury rule less effective compared to policy alternatives, but it tilts the tax code to favor high-tax states.
Under the SALT deduction, taxpayers can deduct state taxes from their federal tax burden, which lowers their federal tax liability. While at first glance, that may seem like a good thing (less taxes is always good, right?), it’s actually a bad policy that effectively allows state governments to avoid the economic consequences of extractive tax policies by passing their federal tax burden off on more fiscally responsible states.
For high-tax states, the SALT deduction is a win-win. They can raise taxes indiscriminately to fund more spending and pet projects, while avoiding the true economic cost of their spendthrift decisions. Meanwhile, the responsibility for funding the federal government is foisted onto taxpayers in states that practice fiscal restraint.
For example, someone making $100,000 in Texas, where there is no personal income tax, can’t write state income taxes off their federal tax burden, although they can deduct state sales and property tax liabilities. Meanwhile, someone making $100,000 in New York City, where their combined state and local top income tax rate would be 10.45%, could write off a substantial portion of their federal tax liability. Consequently, the Texas taxpayer owes more in federal taxes than the New York City taxpayer, despite earning the same income.
The Rich States, Poor States: ALEC-Laffer State Economic Competitiveness Index reveals how poor state tax policy can generate negative outcomes for state economies. For example, the nine states with the highest income tax rates saw 83% lower population growth and 36% lower employment growth than the nine states without income taxes from 2008 to 2018. Each year, more taxpayers and job creators realize they can save money by moving to states with more pro-growth economic policies.
Losing residents and jobs to other states reflects the economic cost of high state tax rates. But, if state taxpayers can write off state taxes from their federal tax burden, poor tax policy becomes less costly for state governments.
So it’s unsurprising that politicians from high-tax states want a full reinstatement of the SALT deduction. For example, Senator Chuck Schumer (D-NY) insisted on reinstating the SALT deduction in the next COVID-19 relief package. And after taking control of the U.S. House following the 2018 elections, Nancy Pelosi buttressed her campaign for Speaker of the House by promising members from high-tax states she would work to fully reinstate the SALT deduction.
The Treasury dealt a serious blow to the SALT deduction cap last month by exempting all businesses except for sole proprietorships from the SALT deduction cap. Now, states with top income tax rates exceeding 10%, like New York, New Jersey and Illinois, have a green light to pursue more anti-business policies. And states with more reasonable, pro-business tax codes are left to shoulder more of the federal tax burden.
The Treasury adopted this rule to correct an imbalance in how the SALT deduction applied to the different types of corporations. The SALT deduction cap applied only to businesses that pay personal income taxes, like S corporations and partnerships. Meanwhile, businesses that paid corporate income taxes, like C corporations, could still claim the full SALT deduction.
The ALEC Principles of Taxation, a series of seven principles of pro-growth tax policy, would support reforming the SALT deduction to treat all businesses equally. The principle of “neutrality” argues tax policy should treat similar taxpayers alike, because an unequal tax code can lead to arbitrary tax policy and harm economic growth as a consequence. Rolling back the SALT deduction cap only serves to reinstate the imbalance between high-tax and low-tax states regarding federal tax policy.
Instead, the SALT deduction cap should have been extended to cover corporations as well, and the net increase in tax collections should have been used to finance tax cuts. Just as individuals in low tax states pay a larger share of federal taxes compared to individuals in high-tax states, so do corporations. Just like with individuals, it is unfair for corporate taxpayers in low tax states to pay a comparatively larger share of the federal tax burden, while high-tax states get to avoid the true economic consequences of anti-business tax policy.
The true imbalance in SALT deduction policy is not how S and C corporations are treated differently. The SALT deduction should be repealed entirely for all taxpayers, business and individuals. As long as the SALT deduction is still on the books, taxpayers in fiscally responsible states will foot the bill for the federal government while spendthrift states continue to avoid the true costs of poor fiscal policy.
Skip Estes is legislative manager at the American Legislative Exchange Council and writes on a variety of nationwide tax and budget issues. Follow him @Skip_Estes.