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Trump Plan to Repeal SALT Deduction Would Hurt States' Ability to Raise Taxes, Experts Say

POSTED ON May 9, 2017
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The Trump administration’s proposal to kill the state and local tax deduction has the potential to hurt states’ ability to raise taxes and would likely generate a backlash from high-income earners, particularly those in Democratic-leaning states.

Experts contacted by Tax Analysts since the reform outline’s release suggested that elimination of the deduction, combined with lower rates and other features of the Trump plan, would cost trillions in lost federal tax revenue and represent a blow to progressive state tax policy.

In its one-page plan released in late April, the administration proposed eliminating most itemized deductions against the federal income tax while doubling the standard deduction, lowering tax rates, and getting rid of the alternative minimum tax, among other reforms. The plan to repeal the SALT deduction — which can be used to deduct from filers' federal liability a portion of their state income taxes or sales taxes — has generated concern among progressive groups.

According to reports, New York Gov. Andrew Cuomo (D) earlier this year warned that such a move could drive higher-income earners out of his state, and state and local government groups have also voiced their opposition to the proposal.

Experts said that eliminating the deduction would end high-tax states ability to rely on the deduction to soften the cost of their progressive tax regimes on high earners.

“There are a handful of states where this is a significant deduction for taxpayers,” said Jared Walczak of the Tax Foundation, noting that six states — including California and New York — are responsible for over half of the total amount claimed through the deduction each year. “It represents 9.1 percent of [adjusted gross income] in New York, compared to a median of 4.5 percent. . . . California is the second highest at 7.9 percent.”

Chuck Sheketoff of the Oregon Center for Public Policy said the effect of the deduction’s repeal on his state would be significant. “If that goes away, that would be a problem for Oregonians,” he said. “We’re very dependent on the income tax.”

Although the deduction can be claimed against sales taxes, most filers who itemize are high earners, so they would save more by claiming the deduction against their state income taxes, according to Matthew Gardner with the Institute on Taxation and Economic Policy. While seven states don’t have income taxes, the regressive nature of sales taxes means the increased burden for those states' itemizers would be far less than for taxpayers paying progressive income taxes.

“The biggest beneficiaries of itemized deductions generally are those with the highest incomes . . . [and] only the personal income tax is really targeted toward the people with the highest income,” Gardner said.

The proposal to repeal the state and local tax deduction was designed in part to balance out the reduced tax rates included in the Trump plan. Overall, high-income earners would probably end up paying less in combined federal and state taxes under the proposal, sources said. But Alan Auerbach, a tax policy expert at the University of California, Berkeley, said that under the proposal, taxpayers in states with high progressive income taxes will still see their state and local tax burden increase relative to their federal liability. Rather than considering the total reduction to their federal and state taxes, taxpayers will "be more sensitive to state and local income taxes, because [they won't be] getting a deduction for it," he said.

The repeal of the deduction would ratchet up taxpayers' resistance to future state tax increases and potentially create pressure to reduce existing income tax rates, he said.

Observers said it's unclear whether the deduction's elimination would cause taxpayers to leave high-tax states, but Alysse McLoughlin of McDermott Will & Emery in New York said it would effectively reduce states' ability to look to tax increases for additional revenues.

“There’s a point at which there’s too high a burden,” she said. “If you look at taxpayers as a whole, the amount they pay is going to in some cases be drastically increased.”

Although states with the highest levies on earnings are those with the most to lose, sources say that repealing the deduction would have at least some effect on all states. Notably, the Trump administration’s proposal to eliminate deductions for property taxes would also hit states with higher property taxes, like Texas.

“All state and local governments lose in this scenario — blue states [just] lose more,” said Chris Hoene of the California Budget and Policy Center. Without taxpayers’ ability to write off some of their state taxes, all states would feel at least some increase in taxpayers opposition to higher levies. That’s “why historically, when the state and local deduction has been challenged . . . state and local leaders have overwhelmingly rejected that idea, regardless of party.”

Deduction Divides Opinion

Repeal of the state and local tax deduction has its supporters. Walczak called the deduction a regressive policy, arguing that it shifts the responsibility of paying federal taxes from high-income-tax states — whose tax regimes are partially supported by high-earners’ ability to subtract state taxes — to taxpayers in less income-tax-dependent states.

The deduction “represents a transfer or a subsidy that encourages greater government spending” in states such as California, Walczak said. “Income tax payers across the country shouldn’t be subsidizing higher-income states and affluent communities” where steeply progressive income taxation is more common, he added.

Walczak said the deduction also makes it politically easier for states and local governments to focus on income and sales taxes to raise revenue, when other means of generating funds — such as fees — might be better from a policy standpoint. Eliminating the deduction could pressure states to consider alternatives to taxes, he said.

Auerbach agreed that the deduction allows states to pass on some of their spending costs to the federal government, but argued that it is not as regressive at critics allege. He said “donor states” such as California tend to send more money to the federal government than they receive as funding in return. “It’s a little unfair to say New York and California are being subsidized,” he said.

Hoene said the deduction’s alleviation of the burden of high income taxes is a way to encourage states to use their taxing authority to fund higher levels of services. Gardner also said it could be argued that greater spending by states with high income taxes has spillover benefits for the rest of the country.

“There’s a sensible view that because state and local governments provide services that offer a national benefit . . . that they should have some recompense,” he said, citing higher education spending as an example.

Some of the Trump plan's critics have suggested that the proposal could in part be targeted at pressuring blue states to reduce their tax rates on high-income households. But simplifying the federal tax code by eliminating deductions has been a long-standing idea. Although progressive groups are critical of the administration’s plan, Gardner said they also favor some reforms to deductions.

“One of the more sensible ideas I’ve heard for itemized deductions generally is changing them into a credit,” he said, adding that it would shift more of the deduction's benefit to lower-income earners. Lawmakers could also accelerate the existing phaseout of the benefit for the highest income earners to capture more revenue, he said.

Sources noted that the Trump proposal would preserve the charitable contributions and mortgage interest deductions, despite the latter being a particular target of criticisms by both liberals and conservatives. Those deductions are too popular to eliminate, and the current plan is also expected to generate strong political opposition, they said.

The administration “will be under pressure . . . from deficit hawks in Congress to taxpayers and state and local government leaders,” Hoene said.

According to Auerbach, the Trump administrations overall tax reform plan would cost the federal government trillions in lost taxes, including from corporate tax cuts. That would make the plan hard to pass. Nonetheless, observers say the proposal to eliminate the state and local tax deduction should be taken seriously.

“It’s certainly conceivable that if they do pass [a] proposal that’s somewhat more responsible, fiscally, that it maintains this provision” eliminating the deduction, Auerbach said.