State and Local Tax Deductions: Moving to a Consensus on Build Back Better

11/10/21

As part of the Build Back Better Reconciliation bill currently under consideration, one of the provisions of the Tax Cut and Jobs Act of 2017 has a good chance of being amended. That is, the cap on the deduction for state and local taxes (SALT) will most likely be raised from $10,000 to something like $72,500. A critical mass of Democrats has drawn a line in the sand, making this change a prerequisite for their support of the bill.

The most vocal proponents of raising this cap are House members from high tax states, where the cap affects the largest number of taxpayers. Raising that cap directly benefits those constituents. The higher the cap, the greater the tax saving, with the amounts of the savings growing as income levels rise. As such, raising the cap is at odds with the orientation of Democrats who generally support making our tax system more progressive — particularly at the upper end of the income spectrum. This piece of the legislation is contrary to that broader, overall intention.

My thinking about this issue starts with the question of whether any deduction for SALT is justified. In a perfect world, the funding requirements of the Federal government versus those of state and local governments are distinct; and taxpayers should be expected to cover the costs relating to their respective locations, wherever they live. Moreover, it’s reasonable to expect that higher taxing states and localities offer a greater range or depth of public services. It’s not like the taxpayers aren’t getting anything for their money; but at the same time, those bearing the highest tax liabilities in high tax states may feel that their tax burden is too large relative to the value of services they might receive. Failing to mitigate these costs for such taxpayers would certainly incentivize some to vote with their feet and move to lower cost areas. The real unintended consequence of capping the SALT deduction would be the lower tax collections realized by cities and states that lose these wealthy taxpayers.

It’s understandable that advocates from high tax states would want to see the SALT deduction allowance to be unbounded, or if not, raised as high as possible. Advocates from low tax states, on the other hand, would reasonably want to see these deductions eliminated in their entirety, as these deductions effectively shift the share of federal funding from high tax states to low tax states. Either way, it seems to be a beggar thy neighbor setup.

I see the threat of migration as real, but one that I’m ready to live with. Ultimately, in response to lower tax collections, taxing authorities would be forced either to alter their collection practices, where those remaining after a flight of the wealthy will necessarily be forced to accept a larger share of the tax burden, and/or services will have to be cut back. Either or both will happen, or the Federal government will have to step in to fill at least part of the void.

Those who favor maintaining SALT deductibility view SALTs as different from other household expenditures in that they are largely non-discretionary. While this characterization may be true for income taxes and even property taxes to a large extent, it may not hold for sales taxes. In any case, however, those holding this view generally argue that federal taxes are better leveled on discretionary income, as opposed to some broader income measure. Excluding SALT moves closer to that ideal.

Critics of the cap also argue that, if a cap must be instituted, $10,000 is simply too low, as it is constraining for far too many working families. It doesn’t just hit rich folks. While that may be true of this feature in isolation, the $10,000 cap was part of a larger package that included raising the standard deductions and an across-the-board reduction in marginal tax rates, all of which resulted in tax saving virtually at all income levels.

It appears that the $72,500 cap for SALT deductions being discussed is the compromise needed to move the broader legislation toward consensus. To me, it shouldn’t be necessary as it takes away from the increased progressivity of our tax system that would otherwise arise. Still, if this compromise is what it takes to pass Build Back Better, I can live with it even though it smacks of pork barrel politics. Sometimes you just have to hold your nose and embrace the suboptimal. In the case of Build Back Better, the good far outweighs the bad.