Americans consume a lot of sodium, and many doctors believe it would do us good to cut back on the salt. The recent debate over federal tax reform has highlighted a different kind of salt that we should also cut: the state and local tax (SALT) deduction.
Many politicians from both sides of the aisle are against cutting SALT, but its elimination will make the tax code more progressive, simpler, and help fund cuts in tax rates, which in turn will help economic growth.
Under current law, taxpayers who itemize their deductions can deduct their state and local income or sales taxes—but not both—and their property taxes from their federal taxable income. The Senate bill would eliminate this SALT deduction altogether, while the House bill would save the property tax portion but cap it at $10,000.
Supporters of SALT argue that taxpayers shouldn’t pay federal taxes on the money used to pay state and local taxes. This isn’t a bad argument, but most people don’t use SALT for that purpose. Instead, they rely on the standard deduction to lower their federal taxable income. In 2014, only 28% of all federal income tax filers itemized and claimed the SALT deduction. The other 72% used the standard deduction.
So despite what SALT supporters say, eliminating it won’t mean that most people will begin paying federal taxes on money used to pay state and local taxes. This is especially true if the standard deduction is doubled, as is the case with the current House bill.
Politicians and voters making the largest uproar about the elimination of SALT tend to be from high-income, high-tax states such as Connecticut, New York, New Jersey, and California. And understandably so; according to the Tax Policy Center, the average deduction in each of those states was over $17,000 in 2014, more than double the roughly $7,000 average in Florida and other southern and western states. Without the SALT deduction, taxes may rise considerably for many people in high-tax states.
But if we want the tax code to be more progressive, this isn’t a bad thing. In general the SALT deduction favors the high-income people of these high-tax states. In 2014, only about 10% of tax filers making less than $50,000 claimed the SALT deduction, while about 81% of filers making over $100,000 claimed it.
Additionally, an analysis from the Tax Policy Center found that 90% of the tax increase from eliminating SALT would be concentrated among earners making over $100,000 per year, and 40% of the increase would be paid by earners making over $500,000. Since many high-income workers live in large, expensive cities on the coasts, it’s not surprising to see a large amount of pushback from coastal states.
In addition to directly benefiting high-income individuals, the SALT deduction subsidizes state and local governments, especially those with high tax burdens. Residents of those areas can offset some of their state and local tax burden by itemizing and claiming the SALT deduction. This makes them more willing to support higher state and local taxes, since federal taxpayers throughout the country are essentially sharing part of the bill.
If taxpayers can no longer claim the SALT deduction, they will be less willing to pay these higher taxes, which will impact state and local finances. Instead of relying on higher taxes to fund larger governments, state and local governments with high tax burdens may have to reevaluate spending priorities and shift to more user-fees.
This highlights another issue created by the SALT deduction. Because state and local taxes can be deducted but user-fees and payments to private providers can’t, state and local governments have an incentive to fund services via higher taxes and to do things in-house.
For example, researchers have noted that the SALT deduction incentivizes voters and officials to fund services such as garbage collection with taxes that can be deducted from federal taxable income rather than privatize them or fund them with user-fees that can’t be deducted. Tax policies like SALT that favor one method of provision over another generate an inefficient mix of publicly and privately provided goods and services.
The United States needs tax reform. Our system is too complex and holds back economic growth. At the same time, we should try to offset rate cuts—in addition to making real spending cuts—so as not to blow an even larger hole in the federal budget. Eliminating the SALT deduction simplifies the tax code and helps offset rate cuts that will spur more growth, while also making the tax code more progressive. It’s not a silver bullet, but it’s a step in the right direction.