It’s an unhappy time to be a high-income professional in a blue state -- or their governor.
The new tax law, which caps the deduction for state and local taxes at $10,000, amounts to a roughly one-third increase in their effective state-and-local tax rate. That will be an ugly hit to the pocketbook.
They will fiercely resist any attempt to raise taxes further, bad news for mayors and governors who are often facing big pension holes that are eventually going to need to be filled with taxpayer money. Worse still, they will probably put pressure on said politicians to lower taxes. And some of them may start shopping for residences in lower-tax locales, taking their valuable, taxable incomes with them if they go.
Small wonder that officials in high-tax states are desperate to find some way to undo what congressional Republicans have wrought. A number of proposals have been floated in the last month, all of them interesting, none of them likely to work very well.
Option 1: Convert state and local taxes into a charitable deduction
From the point of view of these governments, this is by far the best choice. Basically, people in your area pay taxes up to the $10,000 cap. Then you offer them the option to “donate” money to state coffers, and receive a credit against their taxes for the donation. Since charitable donations are still deductible under the tax plan, they get the full benefit of a federal deduction.
Sure, it adds a little administrative hassle. But economically this simply returns those states, and their taxpayers, to the status quo ante.
There’s only one problem with this plan: These governments are not exactly the first people to think “Hey, what if I called this transaction something else -- something less, you know, taxable -- and saved myself some money?” The IRS is keenly alive to this strategy, and has a long history of rulemaking to prevent it. And the tax courts have a long history of backing them up.
Law professor Andy Grewal took a deep dive into the law surrounding this strategy, and came up holding some bad news: “If a taxpayer has a fixed state income tax liability but receives a credit against that liability for any payments directed to state agencies or subdivisions, it is hard to see why the characterization of the payment will change.” In other words: nice try, guys, but this probably isn’t going to work.
Option 2: Get rid of the income and property taxes, and convert them to a payroll tax
Individuals lost their ability to deduct expenses under the new law. But businesses didn’t. So what if state governments zeroed out the income tax, and replaced it with a tax on payrolls? Those taxes would be federally deductible, meaning that states would continue to enjoy a federal subsidy for their spending.
There are some problems with this strategy, however, starting with the fact that payroll taxes tend to be regressive. I suppose you could theoretically levy a graduated payroll tax, but you’d run into another issue: that payroll tax would not offer any deductions. Which means that folks who get substantial deductions now -- for children, for mortgage interest, for 401(k) contributions or educational savings accounts -- would effectively be paying more. You can adjust the rate, of course, but no matter how you fine-tune it, it’s not going to map all that closely onto what folks were paying under the old structure. Some people will benefit, but some people will lose out. And those people will scream bloody murder.
There are also limits to this strategy, because income taxes and payroll taxes require a fair amount of administrative capacity on the part of the government. High-tax states have that administrative capacity, but local governments don’t (and even if they did, they would be loath to slap a wage tax on local businesses that could simply move across the town line to avoid them). So while this might work as a replacement for the state income tax, it won’t substitute for property taxes. And there are plenty of towns in New York and New Jersey where just the property tax can run well north of the cap.
But the biggest problem with this strategy is the effect it will have on employment. Sure, any economist will tell you that workers ultimate pay a payroll tax. Employers view that as a cost of employing you, just like your salary, so if the payroll tax goes up, the wages they’ll offer you will go down. Over the long term, presuming you’ve calibrated the rates right, the difference between the old and new system should be basically a wash.
But no economist will tell you that this will happen instantly. In the short term, you’ll be raising the cost of employing workers, and employers will have a very hard time saying “Hey, you know that big state tax cut you just got? Your wages are being cut by that amount.” Especially not for workers who have long-term contracts or union agreements. So the transition will be rough, and is likely to feature higher unemployment and at least some marginal employers decamping across state lines.
Option 3: Make the federal government give it back
This appears to be the option that New York Governor Andrew Cuomo has settled on for the nonce; he just announced that New York, New Jersey and Connecticut are forming a coalition to bring suit against the feds. This is an intriguing strategy. But alas for the citizens of New York State, probably a doomed one.
I spoke to Michael Dorf, a law professor at Cornell who recently outlined the possible lines of attack that such a suit could take. For one thing, they could argue federalism, a tack that even conservative judges should find appealing. “There’s an argument that the Sixteenth Amendment does not empower the federal government to treat money that is owed to state and local governments as part of the tax base,” he said. “If you go back to the Sixteenth Amendment it’s clear that states were concerned about this at the time of the drafting.”
The problem? “The hard part there for the plaintiff states, while that was a concern for the people who adopted the Sixteenth Amendment, it’s not anywhere in the amendment.”
Alternately, states could say that the new law is under the First Amendment, which protects political expression. “You couldn’t have a law that expressly said Democrats would pay higher taxes than similarly situated Americans,” said Dorf -- and if you can’t do that, you can’t achieve the same end through nominally neutral means.
However, proving that Democrats are being unfairly targeted will probably be difficult. Members of Congress are allowed to seek laws that benefit their districts at the expense of other areas. (Indeed, isn’t that practically the job description?) They’re just not allowed to target people for being Democrats. The defenders of the new law will probably say “We’re not going after people for their political associations; we’re trying to curtail the subsidy to high-tax states.” And Dorf thinks that argument is likely to prevail.
Jonathan Adler, who teaches law at Case Western, was even more pungent, and succinct. While we don’t know what form the complaint will eventually take, since the states haven’t yet drafted it, “What we have seen [so far] would suggest that there is some sort of constitutional right to a SALT deduction. To state the claim is to refute it.”
Given the problems with all of these strategies, it is a measure of state desperation that these are the ideas on the table -- and that they are being seriously considered. In the end, these places may even be forced to consider the truly audacious Option 4: cut their taxes and learn to live within a new, tighter budget.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of “The Up Side of Down: Why Failing Well Is the Key to Success.”
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