SALT deduction

I have generally avoided writing about TCJA’s $10,000 limit on the itemized deduction for state and local taxes (SALT). It is one of TCJA’s features that I have mixed feelings about. I have long felt the deduction needed reform or could be repealed outright, but TCJA’s changes were not what was needed (a bit more on that below). However, my Minnesota-centric perspective compels me to briefly note a recent article in Tax Notes Federal,  Alex Zhang, “The State and Local Tax Deduction and Fiscal Federalism,”(Sept. 24, 2020). Unlike most Tax Notes material, it is available free to nonsubscribers.

Zhang is a Yale Law student and the article won Tax Analysts’ (the publisher of Tax Notes) 2020 student writing competition. Zhang has a PhD (in history) from Yale.

Tax policy experts and academics have given the SALT deduction mixed reviews. For example, they criticize it for, among other things, being regressive and allowing deduction of quasi-personal consumption expenditures. Moreover, there isn’t a simple or obvious justification for it. Zhang’s article recounts these arguments in a literature review. His premise is that the deduction can be justified on federalism grounds. Thoughtful defenders of the deduction tend to turn to some variation on federalism for a rationale.

Zhang contends the deduction is useful or a positive feature because it reduces the uneven pattern of the “balance of payments” (federal direct expenditures less federal taxes paid) on a state-by-state basis – essentially it is a sort of leveling tax expenditure. This uneven pattern has been widely recognized in the popular press and by politicians, particularly those representing “loser” states like New York (i.e., ones who pay more in federal tax than they receive in federal expenditures). Zhang quotes some of this rhetoric. What he does not discuss to any extent is why any of this should matter. That seems to me like a flaw, but no matter. This is a student paper.

Zhang compiles state-by-state numbers on the per capita balance of payments, including his estimates of the SALT tax expenditure before and after TCJA’s limit took effect.  He does a sort of “back-of-the-envelop” calculation for the tax expenditure; using a microsimulation model would yield better estimates. Again, no matter this is a law student paper. What leaped out at me, though, was that Minnesota appeared at the top of his estimates for the worst balance of payments under all three of his measures. The Table lists the per capita amounts for the five states with the largest negative balances as calculated by Zhang. The “Expenditures only” column shows the per capita net federal tax collections, less direct expenditures (federal aid, direct payments to individuals, and direct federal operations such as contracts and payroll). The other two columns incorporate Zhang’s SALT tax expenditure estimates.

State	Expenditures only	Expenditures + SALT	Expenditures + post-TCJA SALT
Connecticut	(4,562)	(3,695)	(4,131)
Minnesota	(7,189)	(6,693)	(6,830)
Nebraska	(4,023)	(3,703)	(3,755)
New Jersey	(5,192)	(4,424)	(4,725)
New York	(2,436)	(1,575)	(2,056)

The numbers for Minnesota are implausible (at least to me). The Rockefeller Institute publishes an annual study (see here for the 2017 version) that calculates annual balance of payment amounts for the 50 states.  It shows Minnesota as more average (a modest balance), not one of the top five “loser” states.  For example, its comparable per capita amount for Minnesota (net of federal expenditures over estimated collections) is a positive $959 (Table 4, p. 15) or an over $8,000 difference from the number Zhang estimated.  

Superficially digging into the numbers, I discovered that Minnesota high number is an artifact of the tax collections or receipts number Zhang used. In making his estimates, he used the Rockefeller Institute estimates of state-by-state federal expenditures but used IRS SOI data for gross collections by state. This caused Minnesota’s amount of federal receipts to go from a $59 billion in the Rockefeller Institute publication to $104 billion in his estimates. He would have been well advised, I think, to use their receipts allocations (see pp. 31 – 33 for their description of how they adjust the IRS numbers). I didn’t try to dig into precisely what inflated Minnesota’s numbers, but assume it is a combination of factors, such as how the IRS reports corporate income tax collections by state. His estimates also caused Nebraska to rise (or drop, depending upon your perspective) in the rankings from tenth (Rockefeller Institute) to fifth largest deficit for about the same reason.

The other Minnesota data point from Zhang’s article that is worth noting is his estimate of the effect of the TCJA’s cutback on the SALT deduction. As I noted above, his estimates are somewhat imprecise since he did not use a microsimulation model like TAXSIM. He calculated them using average marginal rates and distributional data from TPC. In any case, his estimates show that TCJA had a more modest effect on Minnesota than in Connecticut, New Jersey, and New York. He estimates that TCJA reduced the federal SALT deduction tax expenditure in Minnesota by 28%. By contrast, he estimated it reduced New York’s by more than 55%; New Jersey and Connecticut were lower but still higher than Minnesota.  In other words, if he is right, the $10,000 cap had twice the effect in New York that it did in Minnesota.

There is good reason to take this with a grain of SALT. His calculations do not consider the effect of the standard deduction increase or other TCJA changes, aside from the inherent imprecise nature of his calculations. TPC’s state-by-state estimates, available here (see tables A3 and A4 in Appendix) calculated using its microsimulation model, show a much smaller average difference between Minnesota and New York for the effect of reinstating the SALT deduction. The public use database TPC uses for its simulations suppresses or masks the data for the very high income filers (think hedge fund manager and similar in the NYC metro area). That may be a partial factor explaining some of the difference, but I have more faith in TPC’s numbers.

My take

My purpose was just to document what I thought was likely a distortion of Minnesota’s numbers on its balance of payments in Zhang’s calculations. I hope Minnesota readers of Tax Notes (I know there are a fair number of Minnesota tax professionals who are regular readers) are not misled into thinking Minnesota is the biggest loser, so to speak. But I might as well make a couple of more general points about Zhang’s article and on TCJA’s $10,000 SALT limit while I am at it.

Zhang’s article.  My general view is that his underlying premise is misplaced. There is no normative reason for a more even “balance of payments” among the states. To the extent one bothers to make those calculations (politicians are always interested in them – House Research regularly does them for state taxes and aid at the substate levels to satisfy that interest), it does seem appropriate to include tax expenditures, like the SALT deduction, but it is not clear why it should stop at only that tax expenditure. Why not include all tax expenditures? I recognize this would be a herculean task – even for JCT, CBO, or TPC, much less a law student! Just a theoretical observation.

Let’s return to my basic premise that the “evenness” of the distribution seems irrelevant as a policy matter. Federal expenditures can be put into three buckets – grant-in-aid programs (e.g., SNAP and Medicaid), direct payments to individuals (e.g., social security, military retirement, and railroad retirement), and payments for government operations (e.g., the location of military bases and other federal operations). There is no clear reason why any of them should be distributed roughly evenly (per capita) among the states. Consider:

• If one were designing a federal aid program for states (e.g., how much of Medicaid the feds should pay for a given state), a good distribution will have “winners” (typically states with high need and low capacity to pay) and “losers” (states with low need and high capacity). We should not expect or want an even distribution. Distributing aid per capita would not be the correct policy in most cases.
• Federal direct benefit programs with mild redistributive patterns should show a similar pattern. For example, take social security. States with a lot of low-income earners and social security recipients will do better than those with disproportionately more high earners. Because social security is mildly redistributive, residents of states with more high-income earners will pay more tax relative to their benefits. Military and railroad retirement programs will reflect where people choose to live/retire. Medicare reimbursement will correlate with health care costs and higher concentrations of the elderly. All of that seems to be desirable policy.
• Where to locate federal civilian and military installations, which have a big effect on these balance of payments calculations, should be determined on other bases (e.g., where program needs can best be served) and there is no reason to “evenly” distribute them. Of course, we all know that politics is a factor, sometimes a big factor. The southern chairs of congressional committees with jurisdiction over military affairs and spending had a big impact on where military bases were located. But those states also happen serendipitously to often be poor or low-income. So, that political decision may have had some positive redistributive benefits, like a redistributive grant-in-aid program would.

Bottom line: I do not see the relevance of the “evenness” of the balance of payments to the merits of the SALT deduction. It needs to be justified on some other basis.

TCJA’s $10k limit. For some of the reasons put forth by academic critics, I think the SALT deduction is flawed and should be either eliminated or reformed.  While TCJA’s changes failed to improve it, the HEROES Act, which would fully restore it, is also a bad idea.

In my mind, there are two glaring problems (more detail can be found in Zhang’s literature review which contains convenient references to some of the literature) with the pre-TCJA SALT deduction:

1. Regressivity. Higher income taxpayers are both more likely to itemize deductions and to pay more SALT. They are also subject to higher federal income tax rates, yielding more tax savings from the deduction. As a result, they disproportionately benefit, making the deduction regressive. That would not be a problem if the deduction served another purpose, such as accurately measuring ability to pay (income) or encouraging states or local governments to provide appropriate levels of taxation and public services. But there is no basis for concluding it serves either purpose.
2. SALT payments as personal consumption. The reason why the deduction does not serve those purposes is that SALT payments are at least partially a form of personal consumption, which should not be deductible. This is particularly true for property taxes. Homeowners choose where to live (buy a house) and effectively how much property tax they will pay. Buying a larger or higher quality house or a home in a location with good schools and local amenities (e.g., better city services) results in higher property taxes. This is clearly a decision that has strong elements of a consumption choice. If one concludes that the national government needs to nudge or stimulate local governments to tax more to provide more or better services (a federalism rationale occasionally advanced for the deduction), one would certainly not conclude that doing so should provide the biggest benefit to communities whose residents own expensive houses and have high incomes. That is precisely what the deduction does as it applies to property taxes. The relationship is weaker for state taxes and weakest for progressive state income taxes and that policy problem with their deductibility is less (at least in my mind).

So, do TCJA’s changes fix that problem? It is hard for me to make that case or, at least, the problem could have been addressed more effectively in other ways.

On the positive side, with its relatively low ($10K) limit, TCJA dramatically reduced the ill effects of the deduction. It eliminates most of the benefit to very high-income filers, particularly those in high tax states, and reduced much of its regressivity as a result. But it does so in a blunderbuss way.

On the negative side, its pernicious effects remain for homeowners in low tax states (e.g., those without income taxes) and average to modestly above average value homes. They can continue to deduct all or most of their property taxes, which are sensitive to the level of public services, including quality of the schools, that they opt for. By contrast, the much higher standard deduction makes the deduction irrelevant for lower to middle income homeowners. Moreover, the $10k limit has a stiff marriage penalty since it is the same for single, head of household, and married joint filers. When two single taxpayers marry, their combined deduction gets cut in half (a surprising structure for a GOP proposal, I would observe as an aside).

TCJA preserved and slightly enhanced the deductibility of charitable contributions.  SALT payments have many of the same characteristics as charitable contributions – a commonality that is reflected in the attempts by several states to use ersatz charitable contributions as work-around to the SALT limits. Those efforts were quashed administratively by the IRS, correctly in my opinion. But TCJA’s incongruity in the treatment of charitable contributions and SALT payments leads to my final negative observation about TCJA’s SALT limit: it is hard not to conclude that the provision was the result of unseemly political motivation – i.e., the GOP Congress’s desire to punish high tax, blue states. Why else would they leave/enhance the charitable contribution deduction? By itself that motivation should be irrelevant, but it does help to poison the tax legislative process, something to be discouraged.

In that context, it would have taken little effort to come up with a better fix. A simple fix would be to eliminate the deductibility of homeowner property taxes and/or all local taxes. That is where the problem of SALT payments constituting de facto consumption is greatest. It would put homeowners and renters on more equal footing (ignoring the mortgage interest deduction). Because the property tax is universal, it would affect all states more or less equally.

An obvious political objection will be that disallowing only property taxes favors states with income taxes, especially those that rely heavily on them. Nine states do not impose income taxes. (They are all red or purple states, except Washington.) That likely means that their property taxes are higher than in states with income taxes. Put another way, some portion of state income taxes help reduce property taxes. Thus, it may be perceived to be unfair to allow full deductibility of income taxes if property taxes are not deductible. To address that, the income tax deduction could be made subject to an AGI floor (e.g., the first 3% of AGI paid in state and local income taxes could be disallowed). The theory would be that a basic level of income taxes in those states is a substitute for property taxes in states without income taxes. Moreover, it seems very unlikely that people choose to live in a state because it has a progressive or high-income tax. In fact, the conventional wisdom is exactly the opposite – it repels them. So it is unlikely that state income taxes are even close to a quasi-consumption good and a good argument could be made that the progressive element of a state income tax is fully involuntary and thereby should be allowed as an adjustment to income or ability to pay.

Opponents will argue that allowing a deduction for only income taxes will skew state tax decisions, which is an unfair and non-neutral federal intrusion into state and local tax decisions. There is empirical support for the proposition that there will be modest effect on the mix of taxes that states and localities opt for (more income taxes in this case), but not on the overall level of tax and spending. See, e.g., Gilbert Metcalf, Assessing the Federal Deduction for State and Local Tax Payments, NBER Working Paper 14023 (August 2008). That should not be considered a fatal flaw; encouraging a modest amount of progressivity in state taxes seems a reasonable policy given the inexorable growth of inequality over the last 30 years. The alternative is states deemphasizing their progressive income taxes to mitigate concerns over flight of their high-income residents to states with more favorable tax structures. In the long-term, allowing a deduction for a portion of income taxes could help offset some of the regressive effects of eliminating TCJA’s SALT limit.

Finally, this limited deduction for a portion of state income taxes above a basic amount would provide some parity in the treatment of SALT payments and charitable contributions. Conceptually it is difficult for me to see why help for the poor, for example, should be subsidized when done as charitable contributions but not as SALT payments, especially progressive income taxes. See Daniel Hemel, The State-Charity Disparity Under the 2017 Tax Law, 58 Washington University Journal of Law & Policy 189 (2019) for the rationale for treating SALT payments and charitable contributions similarly.

My scheme, of course, would have served none of the congressional GOP’s motivation in passing TCJA’s SALT deduction limit, other than to provide revenue to offset TCJA’s other tax reductions.  And it would be perceived to favor blue states, like California, Minnesota, New York, and Oregon, a death sentence in a Congress where the Republicans have a say. It should have some attraction to the Dems, but they are likely simply fixated on reversing TCJA’s limit. Even in the unlikely event that Biden is president, they command majorities in both houses, and abolish the filibuster, I assume they would listen to the entreaties of their members of Congress representing low- or no-income tax states, rejecting the idea. So, even though it has a reasonable policy justification and is a better approach than the HEROES Act restoration it will be a political nonstarter.  Sigh.