Big Tax Game Hunting: Employer Side Payroll Taxes

This is a great way for progressive states to fight back against this Republican tax scam.
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The Republican Congress gave themselves and their contributors a huge Christmas present with the tax cut bill they pushed through at the end of last year. They decided to cover the costs in part by whacking Democratic states like California and New York, which have relatively high state and local taxes.

The big hit was limiting the amount of state and local taxes that could be deducted. As a result, many upper middle class families and rich families will be paying thousands more in taxes each year.

While most of these people probably can and should pay more in taxes, this tax increase was explicitly designed to make it more expensive for progressive states to provide services like health care and education to their people. In this context, it’s time to take the gloves off. These states absolutely should look to fight back by finding ways to avoid the tax increase.

Fortunately, there is a way. States can look to replace much of their income tax with an employer side payroll tax. This will effectively preserve the tax deductibility of the income tax and even extend this benefit to people who don’t itemize.

To take a simple case, suppose that a state has a 5.0 percent flat income tax. A person earning $200,000 a year would pay $10,000 a year in taxes. Under the former system this $10,000 was fully deductible from federal income taxes, under the theory that this was money they never saw: the state taxed it away.

Now, much of this could be taxable, since the new law limits total deductions for state and local taxes, including property taxes, to $10,000. Depending on how much this person paid in property taxes and other deductible taxes, they may be able to deduct little or none of the money they pay in state income taxes.

Suppose we replace the 5.0 percent income tax with a 5.0 percent employer side payroll tax. The person’s employer will now have to pay 5.0 percent of the worker’s salary or $10,000 to the state.

Economists usually think that employer side payroll taxes are taken pretty much dollar for dollar out of workers’ wages. The idea is that if an employer is willing to pay $200,000 to hire a worker, they don’t especially care whether they are paying that money to the worker or to the government. If the company now has to pay the government a $10,000 payroll tax, they will look to lower the worker’s pay to $190,000.

It is worth noting that this adjustment may now apply everywhere and typically is not going to happen immediately. In other words, we wouldn’t expect that employers will suddenly cut their workers’ pay by 5.0 percent. Rather, workers might see smaller pay increases than would otherwise be the case so that after two or three years their pay ends up being 5 percent less than otherwise would have been the case. (Actually, since employers just got a big tax cut, it would be nice to see them eat some of this payroll tax and let workers enjoy some real wage gains.)

Anyhow, this matters for federal taxes, because after this adjustment takes place this worker would only have $190,000 of taxable income, rather than $200,000. This worker is left with the same amount of money after paying their state taxes as when they had the income tax, but their federal tax burden will be substantially less. If this person is in the 25 percent tax bracket, this little trick saves them $2,500 a year on their taxes.

This benefit goes to even people who don’t itemize. Imagine a more middle income person who earned $60,000 a year before the employer side payroll tax was put into effect. They would see their taxable income fall to $57,000. If they are in the 22 percent tax bracket, they will save $660 a year from this switch.

There will be some complications from this policy. Many people work in one state and live in another. We would want to make sure that this means neither that they escape state taxation nor get taxed by two states. This will require some work but it is a problem that already exists under the current system.

There also is a problem of preserving progressivity. For many reasons it is best to keep a flat payroll tax, but we would want lower income people to pay a smaller share of their income and higher income people to pay a larger share. This can be addressed with an Earned Income Tax Credit, which many states already have and maintaining an income tax for high earners, as well as for income from stocks and other property.

There are undoubtedly other details that have to be worked through and the end product will surely not be perfect. But an employer side payroll tax is a great way for progressive states to fight back against this Republican tax scam.

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