On the last day of March, New York’s legislature approved a budget package that included two provisions designed to get around a punitive clause in the congressional Republicans’ new Tax Cuts and Jobs Act (TCJA).
The TCJA included a limit of $10,000 on deductions for state and local taxes (SALT). While this could be justified as an effort at fairness, since higher-income taxpayers are more likely to take the SALT deduction and are much more likely to pay SALT taxes in excess of $10,000, this was first and foremost an effort to penalize relatively liberal states like New York. These states have higher taxes for the simple reason that they provide better public services than low-tax states like Arkansas and Mississippi.
This shows up both in the form of collective consumption in areas like education and infrastructure, but even more importantly in social safety net spending. According to the Center for Budget and Policy Priorities, the monthly grant for a family of three under the Temporary Assistance for Needy Families (TANF) program in New York was $789 in 2017. In Arkansas, it was $204 and in Mississippi, it was $170. While TANF is a relatively small share of total spending, this does illustrate the different priorities these states place on ensuring that its residents have a decent standard of living.
The limitation of the SALT deduction was explicitly designed to make it more difficult for liberal states to continue to maintain their current level of spending. Under the former system, where SALT taxes were fully deductible and high-income taxpayers faced a tax rate of 39.6 percent, the federal government was effectively picking up 40 cents of every dollar of any additional tax burden that states placed on high-income households.
Under the new tax code, since virtually all of these households will be over the $10,000 cap already, any additional tax burden from state and local governments will fall 100 percent on high-income households. This virtually guarantees much stronger political opposition to any tax increases and quite possibly new efforts to roll back tax rates on higher-income households.
There is also the issue that at some point, higher taxes will cause high-income people to leave a high-tax state, or at least to appear to leave a state, for tax purposes (i.e., to lie about their residence). Research differs on the extent to which this may already be occurring, but there is no doubt that the limit on the SALT deduction brings states closer to this point.
This issue is especially important in a context where the federal government is unlikely to push any progressive initiatives in the near future. If we are going to see any advancements in areas like free college and affordable health care or child care, it will be at the state level. And this is likely to require more taxes.
The fix designed by New York Governor Andrew Cuomo and approved by the legislature includes two routes for working around the SALT limit. One is to create state-run charities to support public education and health care. People can donate to these charities and get the normal charitable deduction on their federal tax forms, which was left in place in the Republican tax bill. The state would then credit individuals for these contributions at a rate of 95 cents on the dollar against their state income tax liability. This should leave high-income households largely unaffected by the limit of the SALT deduction.
The other route replaces a portion of the state income tax with an employer-side payroll tax. This will be voluntary on the part of employers, but workers at firms who take part in this arrangement will face a lower state income tax. The logic of this move is that economists expect that pay will fall by roughly the same amount as any employer-side payroll tax. This means that if a worker gets paid $200,000 a year and the employer starts paying a 5 percent payroll tax, their wage will fall to $190,000. The benefit to the worker in this arrangement is that they only pay federal taxes on the $190,000 in their paycheck, not $200,000. This switch effectively preserves the full deductibility of the state income tax, at least insofar as employers chose to go the employer-side payroll tax route.
For political reasons, Cuomo made the payroll tax an option for employers. However, it is likely that employers with many higher-earning employees (the option is only available for earnings above $40,000 a year) will go this route, since their workers will want to take advantage of the ability to save money on their federal taxes.
This is just a first step in fighting back against the Republican tax plan, but a really big first step. New York’s actions cannot be ignored. Other high-tax states, like California and New Jersey, are considering similar measures. While there have been serious legal questions raised about the charitable deduction route, there is little question that the employer-side payroll tax is an entirely legal work-around. For many decades, states have imposed employer-side payroll taxes for unemployment insurance and workers’ compensation, so this is hardly an innovation.
If liberal states end up adopting these federal tax law hacks, it will lead to the ironic situation where the only people who lose the ability to deduct SALT are higher-income people living in Republican states. That would be a great outcome from this tax battle.