By Adam Thimmesch
The treatment of the state and local tax deduction under the GOP’s tax bill has gotten a lot of attention since the bill’s roll out last week. All else being equal, the proposed changes would disproportionately impact high-income taxpayers in blue states, and that issue is front and center in discussions about the bill. The TCJA is also noteworthy, however, in that it does not propose completely eliminating the SALT deduction as had been previously discussed. Instead, it contains a partial repeal for some taxpayers. That creates some noteworthy distortions that might escape the attention of the average person following these discussions.
Basics on the Deduction and the Proposal
To understand this, some background on the SALT deduction is helpful. That deduction is contained in Code section 164, which allows taxpayers to deduct: (1) state, local, and foreign real property taxes; (2) state and local personal property taxes; (3) state, local, and foreign income, war profits, and excess profits taxes; and (4) the generation skipping transfer tax imposed on income distributions. That section also allows individuals to elect to deduct state and local sales and use taxes instead of state income taxes. Section 164(a) also provides a catch-all in its flush language that allows a deduction for all state, local, and foreign taxes that are not described in the prior list but that are paid or accrued in carrying on a trade or business or an activity described in Section 212. (This will become important later.)
The TCJA would modify Section 164 by creating a new section that limits the ability of individuals to deduct certain of the listed taxes. Specifically, a new Section 164(b)(5) would eliminate the following taxes from the list provided above: (1) foreign real property taxes; (2) more than $10,000 (or $5,000 for married individuals filing a separate return) of state and local real property taxes; (3) all personal property taxes; and (4) all state and local income taxes. The bill doesn’t explicitly eliminate the option for taxpayers to deduct sales and use taxes, but the new section (b)(5) overwrites the provision that currently allows taxpayers that choice.
This is the basic setup of the proposal, but it gets more complicated because the bill’s modifications to the deductibility of real and personal property taxes explicitly do not apply to individual taxpayers who pay or accrue those taxes in carrying on a trade or business or an activity described in Section 212. Those are explicitly carved out. State income taxes do not get the same treatment, but the bill also does not modify the flush language described above. This structure has led to some confusion.
Analyses of the TCJA’s Approach to the SALT Deduction
As expected, commenters have evaluated the proposed changes to the SALT deduction from a number of angles. Many of those evaluate the distributive impacts of this proposal from economic and political perspectives. I won’t list those here because you can find them on almost any platform. I do, however, want to note two specific analyses that focus on the distortive effects created by the (potential) partial removal of the SALT deduction.
Employees versus Business Owners: David Kamin has an excellent series of posts (here, here, and here) evaluating the potential for differential treatment of employees and business owners with respect to the SALT deduction. This occurs largely due to how the bill treats SALT deductions for taxes that are paid or accrued in connection with business activities.
Recall that the bill explicitly retains the deductibility of property taxes that are so paid or accrued but that it does not mention income taxes. It thus seems to completely eliminate the deduction for the latter. But not everyone agrees. Most important among them are Ways and Means Republicans. As David notes in his posts, they have suggested that non-employees would retain the ability to deduct state income taxes paid or accrued in connection with their business activities, but aren’t exactly being transparent about this point. David explains this in his posts, and the issue has also been reported and confirmed by other media outlets.
The language of the bill doesn’t directly provide this result. As noted above, the bill provides very plainly that individuals cannot deduct state and local income taxes, and there is no carve out for those taxes that are incurred in connection with a trade or business. The answer is presumably found in the flush language of Section 164(a) (noted above). The argument on this point is strong, but this hasn’t been provided as the explanation by those in the House.
Presuming for a moment that income taxes paid or accrued in connection with a trade or business or a Section 212 activity do remain eligible for a deduction, it is clear that employees would not be able to take it—or the retained deduction for business-related property taxes for that matter. Employees are engaged in a trade or business, of course, but the trade or business of being an employee remains disfavored under Section 62. That means that the deduction would not be allowed above the line. In addition, Section 1312 of the TCJA would create a new Code section 262A that explicitly provides that “no deduction shall be allowed with respect to any trade or business of the taxpayer which consists of the performance of services by the taxpayer as an employee” other than those that are allowed in determining adjusted gross income. This means that employees are just out of luck.
If this analysis is right, then the TCJA would give a big relative tax advantage to non-employees. That includes passive investors, law firm partners (but not law firm associates), and anyone who can structure their affairs to provide services through a pass-through entity rather than directly as an employee. Not only are those results normatively questionable (at best) and of significant economic consequence, but they would serve to distort behavior by providing a tax preference for particular forms of business activity or arrangements.
That distortion would, of course, be in addition to the distortion created by the TCJA’s proposed special rate for passive income. Dan Shaviro critiques these aspects of the TCJA here (SALT) and here (passive income). He is not alone in his critique. I won’t go into the passive-income provisions here to keep my focus on SALT, but I have a feeling that we will be hearing much more about this issue as the bill moves forward.
States versus Local Jurisdictions: The structure of the SALT deduction under the TCJA would also distort behavior at the state government level. Daniel Hemel has rightfully pointed out that the proposed plan would, all else being equal, provide an incentive for states to rely more heavily on property taxes and less on income taxes. (For more on this, see here.) Of course, all else is not equal. States cannot freely shift between the different types of taxes overnight. Legislation takes time, state interest groups are sure to protect their constituents, and there may be constitutional limitations that would prevent states from immediately increasing their property taxes. Daniel notes these considerations, and they are certainly accurate.
One other important aspect of this shift, though, is that income taxes are generally state-level taxes and property taxes are generally local. States don’t just pull down on the income-tax lever and push up on the property-tax lever. Local property taxes are set by local jurisdictions based their needs, the assessed value of property within their jurisdictions, and the levels of tax that they are allowed to impose for particular purposes.
This structure is very important. For a state to shift its residents’ overall tax burdens more heavily onto property taxes, it would need to either impose or increase a state-level property tax or cause local governments to increase their taxes. The latter can be achieved somewhat covertly by simply increasing local jurisdictions’ needs. That can be done, in turn, by (1) making local jurisdictions responsible for a greater number of public services or (2) decreasing the amount of state aid provided to local jurisdictions for the public services that they currently fund. A state could also, of course, do both.
This state-level control over local funding needs has long created tension in state and local tax debates. It allows state governments to cut state-level taxes while simply passing the buck (along with the political blame) to their local counterparts. The TCJA would exacerbate the issue by giving state-level politicians another reason to engage in this behavior. Not only would they get the same political points, but they would provide real economic gains to certain of their constituents. I’m not sure how this would ultimately play out given all of the other factors involved, but it seems like something worth considering.
If these discussions have you feeling under-educated on state and local tax matters or just interested in learning more about the policy implications of the SALT deduction, fear not. Scholars have done great work in recent years to flesh out some of the finer points of these issues. The literature is obviously large, but the following articles and blog posts should be helpful for people who are new to this area and interested in understanding more.
- Brian Galle (Short): Why Red States Should Love the State & Local Tax Deduction
- Brian Galle (Long): Federal Fairness to State Taxpayers: Irrationality, Unfunded Mandates, and the ‘Salt’ Deduction
- David Gamage and Darien Shanske (Long): Tax Cannibalization and Fiscal Federalism in the United States
- Daniel Hemel (Short): Easy on the SALT — A New Paper on the Deduction for State and Local Taxes
- Daniel Hemel (Long): Easy on the SALT: A Qualified Defense of the Deduction for State and Local Taxes
- Gladriel Shobe (Short): The GOP gets a big part of its tax plan backward: State, But Not Local, Taxes Should Be Deductible
- Gladriel Shobe (Long): Disaggregating the State and Local Tax Deduction
None of these discussions praise the SALT deduction as an ideal piece of tax policy. Yet, it is important to remember that no individual aspect of a tax-reform proposal can be evaluated alone. A recent paper by Daniel Hemel and Kyle Rozema illustrates this nicely. That paper demonstrates how even the repeal of a tax deduction that disproportionately benefits high-income taxpayers can result in a more regressive tax system at the end of the day. The key consideration is what Congress does with the money (e.g., does it use it to lower rates across the board, to eliminate the estate tax, to increase the EITC, etc.). This is a crucial aspect of the reform discussions that are taking place, and should be on everyone’s mind as debates move forward.