It Won't Be Easy For Blue States To Dodge The GOP Tax Law

Democratic efforts to offset the lost state tax deductions are fraught with practical and political problems.

WASHINGTON ― As Democratic policymakers at the state level attempt to craft legislative responses to the tax bill that Republicans rushed through Congress last year, the difficulty of the task is becoming clearer.

To offset the revenue lost from corporate giveaways, Republicans limited the amount that people can deduct from their federal taxable income for what they’ve paid in state and local taxes.

The new law puts a $10,000 limit on the state-and-local tax deduction ― tax wonks call it the SALT deduction ― which primarily disadvantages high-income taxpayers in so-called “blue states” with higher taxes.

That SALT deduction limit has sparked anger among blue-state politicians, both because they’re miffed that Republicans explicitly targeted their states and because they fear that a smaller deduction could undermine crucial political support among their own residents for the state taxes that finance more generous social spending.

New York Gov. Andrew Cuomo (D) on Thursday called the tax legislation a “federal economic assault” on New York.

But efforts to spare upper-middle-class taxpayers from the hit they would take from the reduced SALT deduction get complicated fast. For one thing, policy experts note that it would require state governments to bend over backwards to accommodate households with six-figure incomes that Democrats fret are already doing just fine.

“If your complaint about the tax bill was that it was too expensive and gave too many tax cuts to the wealthiest Americans, I’m not sure why you would double down with these SALT workarounds,” said Marc Goldwein, a senior fellow with the Committee for a Responsible Federal Budget, which opposed the tax bill because it will add to the national debt.

New York Gov. Andrew Cuomo (D) is trying to find ways to shield state residents from the adverse effects of the Republican tax legislation.
New York Gov. Andrew Cuomo (D) is trying to find ways to shield state residents from the adverse effects of the Republican tax legislation.
Santiago Felipe via Getty Images

More insidiously, a major proposal in New York state to offset the lost deductions would deprive Social Security and Medicare Hospital Insurance of revenue they would otherwise receive under the current tax regime.

Cuomo’s main proposal would shift some of the burden of New York state’s income tax from individuals to their employers. The plan, which would be voluntary for businesses to join, would phase in a 5 percent tax on annual wages above $40,000 to be paid by employers. Businesses could then deduct those taxes off their federal returns, since they are still allowed to deduct compensation costs under the new tax law.

Meanwhile, workers in participating companies would be given an equivalent state income tax credit. In the end, the state would presumably receive the same amount of revenue from its income tax.

But there’s an unintended, albeit expected, wrinkle. Employers opting in to the Cuomo plan would likely respond to the new state-level payroll tax by reducing their employees’ gross pay by an amount commensurate to the new tax they would shoulder. The Cuomo administration argues that since the new state tax phases in over time, employers may choose to reduce annual wage increases rather than cutting current pay levels. Moreover, they say the state tax credits will ensure that workers still come out ahead.

By essentially encouraging employers to reduce their workers’ pre-tax pay, however, Cuomo’s plan would also reduce the amount of wages subject to the federal payroll taxes that fund Social Security and Medicare.

To pay the 5 percent tax on a worker earning $80,000, for instance, an employer might reduce wages by $2,000, meaning only $78,000 would be subject to federal payroll taxes. If that person continued to earn a similar salary until retirement, he or she would receive about $300 less in annual Social Security benefits, said Dean Baker, a labor expert with the liberal Center on Economic and Policy Research.

Baker downplays that possible effect. “I know that people opposed to it will complain about this, but the plausible impact on Social Security benefits is almost sure to be very trivial,” he said.

The Social Security trust fund overall could also take a hit, depending on how many blue states adopt such a plan ― if, say, New York, Illinois and California, all populous high-tax states, went this route. That effect could be limited, however, by the fact that Social Security taxes apply only to the first $128,400 of wages.

“It’s brand-new and it will be hard to explain.”

- Teresa Ghilarducci, a retirement security expert at the New School

But there is no ceiling on pay subject to the Medicare portion of the federal payroll tax. That tax provides revenue to the Hospital Insurance trust fund, which pays for Medicare’s hospital coverage for seniors and people with disabilities. The Hospital Insurance trust fund is already under some strain. On its current course, it will be unable to fund 100 percent of benefits beginning in 2029.

“The Hospital Insurance trust fund would clearly lose,” said Paul Van de Water of the Center on Budget and Policy Priorities, a progressive think tank.

Teresa Ghilarducci, a retirement security expert at the New School, was not particularly concerned about the Cuomo proposal’s impact on Social Security’s finances. She was more worried that the benefits of the plan would be hard to communicate.

“It’s brand-new and it will be hard to explain,” Ghilarducci said.

Another proposal within Cuomo’s plan, and one that Democrats in other states are also considering, is to allow taxpayers to make “charitable contributions” to the state in lieu of tax payments. Since people can still count charitable donations against their federal taxable income, this strategy would allow states to maintain their own revenue without their residents paying higher taxes overall.

Both the charitable donation strategy and the business payroll tax plan would face skepticism from the U.S. Treasury and the Internal Revenue Service, said Larry Zelenak, a tax professor at Duke University. On the question of payroll taxes, he said the IRS might want to classify something like the New York proposal as a disguised withholding of state income tax, which would need to be included in workers’ federal taxable wages.

“I can imagine even the Obama IRS saying this wouldn’t work,” Zelenak said.

The original idea of allowing people to deduct state taxes from their federal taxes was bad to begin with, said Matt Bruenig, founder of a progressive think tank called the People’s Policy Project. In an analysis published last month, he estimated that 70 percent of the benefits of that deduction went to people earning $200,000 or more.

If blue-state lawmakers are concerned that the reduced SALT deduction will turn influential, upper-middle-class taxpayers against generous state spending on schools and roads, they could simply reduce state taxes on those households and make up the difference with tax hikes on “even richer people,” Bruenig said.

But anything that serves to reduce federal payroll taxes at this point, he said, “is not good. In general, I think we need more payroll taxes to pay for more and more benefits.”

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