SALT Deduction Changes Could Improve State Tax Systems Too

Thirteen law professors have written about how the GOP tax plan will provide incentives for tax planning and behavioral changes that might undermine current revenue estimates.

The document, “The Games They Will Play: Tax Games, Roadblocks, and Glitches,” is clearly written by professors skeptical of the overall tax package. But it provides useful examples of potential problems, such as ways new passthrough provisions could lead to complex battle lines between tax authorities and taxpayers.

It also assesses how the elimination of the state and local income and sales deduction (SALT) from the federal income tax code might encourage changes to state tax systems. Remember both House and Senate Bills would only retain a deduction of up to $10,000 for property taxes.

The restriction of the SALT deduction will, ceteris paribus, raise the cost of state and local government expenditures for affected taxpayers, particularly in higher-income, higher-tax jurisdictions. That might be expected to put pressure on states to reduce spending—a feature of this reform, rather than a bug.

But according to the professors, states may also seek to “reshape their tax systems so as to respond to this change and retain the benefit of the deduction for their taxpayers.” One means is to shift towards collecting more revenue from deductible taxes.

How might they do so?

One way for states to achieve this is by shifting to use of the property tax. The liquidity impact on taxpayers of a shift to property taxes can be mitigated by circuit breakers administered through a state’s income tax—essentially, reducing income tax liability in exchange for higher property taxes. Such responses would effectively allow taxpayers to deduct the full amount of state and local property and income taxes, up to the $10,000 cap.

Now, the professors paint this as a bad thing, because they believe it means federal revenue losses from tax reform will be greater than currently projected. From an economic perspective though, property taxes are broadly regarded as being less distortionary to economic decisions than income taxes. They also tend to encourage localism, and given they are widely disliked (particularly by elderly constituencies who turn out in elections), may be even more effective at bringing attention to the scale of state government spending than an increased income tax burden.

Whilst it would be better to have no SALT property deduction at all, if a consequence of tax reform is states using property taxes instead of income taxes, then that could be a good thing for the economy.