State and Local Tax Deduction: Taking Proponents' Arguments with a Grain of SALT

The Tax Cuts and Jobs Act (TCJA), which passed at the end of 2017, was the most comprehensive tax reform the United States has had in about three decades. The TCJA has not been without controversy. One of the most controversial provisions of the TCJA was the state and local tax (SALT) deduction. Essentially, the SALT deduction allows federal taxpayers who itemize their deductions to deduct certain state and local government taxes from their gross income on their annual federal income tax forms. Prior to the TCJA, there was no limit as to how much could be deducted. The TCJA changed that by putting a $10,000 cap on the SALT deduction. Yesterday, the Democrats held a House Committee hearing on whether it should be repealed. As the backdrop of a highly polarized country suggests, the Democrats are largely for the SALT deduction, and would like to see the cap removed. Before getting into the merits of the SALT deduction, I would like to ask a key question first.

Who benefits from the SALT deduction?

This question is important because it helps set the tone of the discussion, particularly in how the tax code should and does function. To start the discussion, only 30 percent of taxpayers itemize their deductions. This means that 70 percent of Americans do not benefit from the SALT deduction because they use the standardized deduction. For those who do end up claiming the SALT deduction, it is interesting who claims it.

First, a look by income bracket. The individuals that benefit from the SALT deduction the most are upper income households. When the Right-leaning Tax Foundation had their representative, Nicole Kaeding, testify yesterday, she pointed out that prior to the TCJA, 91 percent of those who filed for the SALT deduction had an income of over $100,000. The Tax Foundation is not the only one to make this claim. The Tax Policy Center, which has a slight lean to the Left, had similar findings. If that weren't enough, the Joint Committee on Taxation (JCT) released a report on the SALT deduction about a week before the hearings. What did the JCT find? Those who make over $1 million receive 52 percent of the benefit of the SALT deduction. If the SALT deduction cap were repealed, it would be a $40.4 billion tax cut that would go to millionaires (JCT, p. 14).

As the Tax Foundation shows, putting a cap on the SALT deduction (combined with raising the standard deduction) made the tax code more progressive. 

The income brackets only tell a part of the story. Geography, particularly on the state level, plays a role, as well. Prior to the TCJA, a majority of the deduction claimed in dollars came from six states: California, New York, New Jersey, Illinois, Texas, and Connecticut. These six states only made up 38 percent of the population prior to the TCJA, in spite of claiming a majority of the deductions. It would be an oversimplification to state that states with high rates of taxation benefit the most, especially since Texas is one of the top beneficiaries (although Texas does rely heavily on property taxes). Rather, those who stand to benefit the most are high-income earners, many of whom live in high-tax states.

How the SALT Deduction Cap Affects State Budgeting
At first glance, the Democrats' response is perplexing. After all, the position of many Democrats as of late has been to "soak the rich with taxes," whether such proposals come in the form of increasing the marginal tax rate to 70 percent or enacting a wealth tax. Since the SALT deduction disproportionately benefits the rich, you would think that the Democrats would be the ones for a SALT deduction cap or even the repeal of the tax deduction. The reason why the Democrats are opposed to the cap has already been hinted at.

The SALT deduction has disproportionately benefited states with higher taxes. Why? Because the SALT deduction acts as "an indirect federal subsidy by decreasing the net cost of nonfederal taxes." As such, this incentivizes state and local governments to enact higher taxes (Tax Policy Center) because every time a state decides to increase its taxes, those who itemize get a larger federal return. The Congressional Research Service (CRS) found in 2017 that a cap leads to moderate declines on state and local government spending.

This incentive would explain why New York Governor Andrew Cuomo warned in 2017 that a SALT deduction cap would destroy New York. It explains why congressional members from New Jersey and Illinois, two states affected by the SALT deduction cap, are the ones trying to reform the SALT deduction cap to something closer to what it was prior to the TCJA. Although it is a regressive tax that benefits the rich, the reason the Democrats are for repealing the SALT deduction cap is because it would effectively lead to higher taxes and greater government expenditures.

Responding to Proponents for Repealing the SALT Deduction Cap

There are other considerations to respond to beyond tax progressivity and state budgeting. Here are some of the other misconceptions and responses surrounding the SALT deduction.

1. Capping the SALT deduction is not double taxation. Proponents of the SALT deduction assume that double taxation is the result of a SALT deduction cap or repeal. This is a misunderstanding of double taxation. When one pays a tax on shareholder dividends, for example, that income has already been taxed once through the corporate income tax. In this example, there are two layers of taxation taking place. That is not what happens with capping the SALT deduction. Federal dollars go to pay for federal services, and state dollars fund state services. As the bipartisan Committee for a Responsible Federal Budget (CRFB), Tax Foundation, and the National Taxpayers Union Foundation point out, this is not double taxation. The problem here is not the non-existent double taxation, but rather the high levels of taxation at the state and local level.
2. The SALT deduction is expensive. Prior to the TCJA, the SALT deduction was one of the most expensive tax breaks, amounting to $103 billion in 2017. If the Democrats succeeded in removing the cap, it would cost an extra $500 billion over the next six years (CRFB). 
3. Inducing higher municipal debt. As the Heritage Foundation argues in its white paper on repealing the SALT deduction, the SALT deduction also creates excessive and inefficient infrastructure decisions on the local level, thereby driving up municipal debt. 
4. Addressing General Criticisms of the TCJA. The two main criticisms of the TCJA have been that the TCJA benefits the rich and that it costs the taxpayers too much money. Guess what would happen if you removed the cap? Both of those criticisms would be magnified. 

Conclusion

In short, the SALT deduction is expensive, regressive, creates perverse incentives for states to increase state-level taxes, and subsidizes states with higher earners and higher income and property taxes. The SALT deduction is a distortion of the tax code that hides the real cost of taxation and willingness of taxpayers to pay for public services. The SALT deduction cap is a preferable policy alternative to the SALT deduction unhinged, although I would have been more amenable to a SALT deduction repeal with equalization grants, as Niskanen Center fellow Joshua McCabe argues. If we want a fairer, simpler, and less expensive tax code that doesn't subsidize the wealthy or incentivize wasteful spending, then the last thing we need to do here is repeal the SALT deduction cap.