Tax Reform And The State And Local Tax Deduction
Ryan Ellis , CONTRIBUTOR, Forges Magazine
In this Jan. 14, 2017, photo, tax professional and tax preparation firm owner Alicia Utley reaches for hard copies of tax forms while working to stay caught up on a Saturday at the start of the tax season rush, in her offices at Infinite Tax Solutions, in Boulder, Colo. The IRS will begin accepting returns on Jan. 23, and tax experts recommend that Americans continue to file their returns early
Back in June, 70 blue state Congressmen–including 20 Republicans–sent a letter to Treasury Secretary Steven Mnuchin urging that the itemized deduction for state and local taxes be retained in tax reform.
The important figure there is the 20 Republicans on the letter, nearly enough by themselves to scuttle a tax reform package. They have to be accounted for somehow by policymakers crafting a tax reform package.
What is the state and local tax deduction (SALT)?
Under current law, some 30 percent of taxpayers itemize their deductions, as opposed to the 70 percent who claim the standard deduction. Within the minority of itemized deduction families, the big write offs are the mortgage interest deduction, the charitable contributions deduction, and the deduction for state and local taxes paid. State and local taxes include state and local income taxes (state and local sales taxes in non-income tax states), as well as property taxes on homes.
According to the Office of Management and Budget (OMB), the SALT reduces federal tax revenues by just under $1.3 trillion over a decade. The Tax Foundation thinks it’s closer to $1.8 trillion. Whatever the number, it’s a huge revenue impact that can’t just be ignored if tax reform is going to happen.
More than the numbers is the SALT’s effect on the size of government. When a New Jersey or a California is getting ready to raise taxes, they know that their citizens will get back 30 or 40 percent of the tax hike on their federal income tax returns thanks to this deduction. The SALT makes it easier for blue states to stay blue and get even bluer
The SALT is a bigger deal in some states than others. Trump voting states don’t rely very heavily on the SALT at all. Trump voters are much more likely to live in red states than blue states, and are far more likely to be standard deduction families no matter where they live:
Nonetheless, there are enough House Republicans from SALT deducting blue states to matter in tax reform. How to handle it? Below is a three step plan for getting these blue House Republicans on board with a change to SALT.
Remind them that we’re also eliminating the alternative minimum tax (AMT). Just like the SALT is a big blue state write off, the AMT is a big blue state headache. Some 5.2 million families, almost entirely from blue states, are still trapped in the AMT according to the Tax Policy Center. This number will rise to 5.6 million families by the end of the decade. One of the things that happens when you’re an AMT taxpayer is that you don’t get to write off your SALT. By killing the AMT, over 5 million taxpayers who today can’t deduct SALT will be able to.
Cap SALT at a very high level. Tax reform should not look to eliminate the SALT deduction outright–rather, it should expand the total number of SALT deduction families (by eliminating the AMT), and then put a very high cap on the SALT deduction level. Something like $20,000 or $25,000 for a married couple ought to do it (maybe even lower). The interactive effects of a SALT cap and an an AMT repeal would be more constituents in blue states claiming the SALT, but the distribution of who claims it would be more progressive than today–top income earners would no longer be able to use the SALT even as the 5 million mass affluent freed by AMT repeal can. Most of the revenue incidence of the SALT occurs at the top of the income ladder, so a cap will still allow tax reformers to get some valuable tax pay-fors.
Index the SALT cap to nothing. The temptation will be to index a SALT cap to inflation. That would be a mistake. In this case, inflation is your friend. Index the cap to nothing and let more and more people, very slowly over time, see their SALT deduction limited. Assuming 2.5 percent inflation, the SALT cap will be cut in half in real terms every 30 years or so. When combined with measures like doubling the standard deduction (which should nearly eliminate itemizing) and limiting itemized deductions overall, the SALT will become less and less of a political hot potato over time.