SALT Blawg – State and Local Tax Blog
State and Local Tax ("SALT") blog issues require state and local tax knowledge. Chamberlain Hrdlicka's SALT Blawg (SALT Blog) provides exactly that knowledge with news updates and commentary about state and local tax issues.
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The SALT deduction cap, enacted by a Republican-controlled Congress in 2017, is a quagmire for Democrats. They’ve made promises to repeal it, and have made a wedge issue out of it. But repealing the cap would be regressive (it would benefit higher-income earners), which contradicts the party’s broader platform.
Aside from repeal, leaders in the kill-the-cap campaign have sought to undo the SALT deduction cap by challenging its constitutionality in court and by enacting State statutes that seek to end-run the cap (known as “workaround statutes”). But challenges to the cap’s constitutionality in court appear doomed. And the patchwork of workaround statutes that States are enacting has a more regressive and more inequitable effect than even legislative repeal would have. For this reason, if the Democratic Party’s internal politics conclude that the SALT deduction cap must be undone, repeal may be the preferred strategy, as well as the approach most likely to succeed while they control Congress.
However, many Democrats (and other once-critics of the cap) are no longer willing to die on this hill. Cracks are emerging in a once-seemingly-united front against the cap as public awareness grows that removing the cap will be regressive. While the regressive nature of the SALT deduction and removing its cap is not solely an issue for Democrats, because Congressional Democrats are confronting these issues at this very moment in connection with a proposed $1.75 trillion tax-and-spending plan, and are the party in power, this Blog installment focuses on the conundrum that faces the Democratic Party.
Repealing the Cap is Regressive
As a preface, there are critics (as well as proponents) of the cap that hail probably from every walk of life and political stripe. But the charge to kill-the-cap has been led most prominently by the Democratic Party and a handful of high-tax States that in recent election cycles have tended to vote more Democrats than Republicans into office, often oversimplified as “Blue States” for shorthand. In light of the regressive nature of the SALT deduction, the Democratic Party’s position as its defender is not necessarily an intuitive juxtaposition.
And make no mistake about it, the SALT deduction (and lifting the cap) is regressive, a point policy wonks have been making for decades and on which there appears to be no genuine dispute. In connection with the Tax Reform Act of 1986, Treasury analyzed the disproportionate benefit the SALT deduction bestowed upon high-income taxpayers residing in high-tax States. It explained that two-thirds of taxpayers do not itemize their deductions and thus receive no value from the SALT deduction. It also explained that even itemizing taxpayers receive relatively little benefit from the deduction unless they reside in a high-tax State.
In short, the deduction’s value to an individual depends on where they live and how much they make. Earlier this year, the Congressional Budget Office and various think tanks added to the growing body of data. Democrats, after they assumed control of both the Legislative and Executive branches, introduced bills including HR 5377 to repeal the SALT deduction cap. In scoring the bill, the CBO estimated the repeal would cost up to $88.7 billion per year. A study by the Center for American Progress estimated that more than 50% of the benefit of the repeal would go to the wealthiest 1%, and 97% of the benefit would go to the top 20% percent. Without much fanfare, the bill died in committee.
Now, Democrats are revisiting what to do with the SALT deduction cap in connection with the President’s $1.75 trillion tax-and-spending plan, which is still being shaped at the time of this writing. Some Progressive Senators, such as Bernie Sanders, have called out the regressive nature of repealing the cap, decrying the repeal of the SALT deduction cap as “beyond unacceptable.” There has been discussion about making the repeal less regressive by limiting the taxpayers to which the repeal would apply, or by raising the cap but not altogether eliminating it. These ideas nibble around the edges but do not altogether neutralize the disparate benefit of the cap across the income spectrum or between fiscally diverse States. Geographic and socioeconomic inequities would persist under any of the plans that have been floated.
Readers should note that regressive-ness is not the only policy feature of the SALT deduction. Historically, proponents of the SALT deduction have raised countervailing policy issues. In the very first Federal income tax in this country, enacted in 1861, records reflect Federalism and double taxation were key drivers for the deduction, and these concerns continue to linger. For close to a century, it’s unclear if it even dawned on policy-makers that the deduction was regressive. Indeed, the SALT deduction was widely popular; it united rather than divided the main political parties.
In connection with the Tax Reform Act of 1986, a broad bipartisan coalition in Congress voted in favor of a “Sense-of-the-Senate” that emphasized several of these points including that the SALT deduction remained a cornerstone of Federalism, and was exceedingly popular and should not be repealed. A prior blog installment, The History of the SALT Deduction (click here), places these events and policy concerns within a broader historical context.
Regardless of these other policy points, the regressive nature of repealing the SALT deduction cap presents a conundrum for Democrats. Repeal conflicts with other tenets of the party’s platform, and undercuts the “equity” rhetoric of much of the party. There is also the more practical issue of cost: How to pay for the $1.75 trillion spending plan. Repealing the SALT deduction cap would add to the magnitude of revenue-raising offsets necessary to fund the package. Budgetary gimmicks, such as temporary repeals, are circulating to reduce the 10-year budget window’s cost of the repeal. They indicate what a trap the SALT deduction cap has become.
Alternatives to Repeal are Worse
If Congress doesn’t act, two munitions would remain in the anti-SALT-cap arsenal: judicial challenges on grounds the cap is unconstitutional, and state law workarounds. But neither of these is likely to succeed in any useful way.
Challenging the SALT cap in court may be an exercise in futility. Such a challenge would – and is – being heard by the least political branch of government, the judiciary. On October 5, the US Court of Appeals for the Second Circuit rejected a challenge in the leading (and only) case brought by the States of New York, New Jersey, Connecticut and Maryland. The Court’s decision was issued by a three-judge panel consisting of two Obama-appointees and one Clinton-appointee. The lower court judge, an Obama-appointee, had reached the same conclusion. The fight may not be over, but the odds are heavily against the Plaintiff-States seeking to strike down the SALT cap, particularly now that Democrats control Congress and could simply repeal the cap if it really is repugnant to the Constitution. For those interested, the effort to use the judiciary to overturn the cap is the subject of a separate blog installment, Court Rejects SALT Cap Constitutional Challenge (click here).
State workaround statutes, for their part, compound the geographic and socioeconomic inequities inherent in the SALT deduction. Close to half of the States have enacted or are close to enacting statutes that would end-run the SALT deduction cap in the Tax Cut & Jobs Act. Many of these States might be pigeon-holed as “Blue States” but there are “Red States” and “Purple States” in this mix as well. The consequence is that a Federal law (the cap on SALT deductions) intended to apply to similarly situated taxpayers throughout the country is applied differently depending upon a taxpayer’s geographic location. Residents of some States can end-run the cap (and receive an uncapped SALT deduction) while residents of other States can’t. Moreover, within States that have workaround statutes, the distribution of the benefits of the SALT deduction across the income spectrum tends to be less equal than if the SALT deduction cap were simply repealed. Prior to the cap, the SALT deduction was regressive for several reasons, the greatest being that those who took the standard deduction – typically taxpayers lower on income spectrum – received no benefit—and with the expanded standard deduction, even fewer taxpayers could take advantage of itemizing. Workaround statutes tend to enhance the SALT deduction’s regressive qualities because they typically present additional barriers-to-entry for the average Joe.
Let’s look at recent data from New York which enacted the prevailing workaround model—the pass-thru entity model. This model, which has become almost the universal approach that States have adopted, has its variations but basically it allows taxpayers with pass-thru entities to receive state tax deductions via the pass-thru entity which is not subject to the cap because the cap applies only to individuals. Of course, not everyone has a pass-thru entity to stuff deductions into. New York’s Department of Taxation and Finance released data regarding the 2021 tax year. It reports that 95,000 taxpayers registered a pass-thru entity eligible for the workaround statute, and about 1 million taxpayers could register such a pass-thru entity. In a State with over 20 million people, that’s less than 5% of the population that could benefit from New York’s workaround strategy. New York did not release the income levels of the 5% of the population that could use the workaround statute, but it’s doubtful this 5% distributes evenly across the income spectrum. We should expect data from other States with workaround statutes, once gathered and reported, will paint a similar picture of regressivity.
Bottom line is that workaround statutes have a more regressive effect than repeal. They also exacerbate a policy concern that led to the cap in the first place: residents of low-tax States subsidizing high-earning residents of high-tax States. The SALT deduction, essentially (it’s much more complicated than this), lowers the Federal effective tax rate for people in high-tax States more than it does for people in low-tax States because the former receives larger Federal tax deductions than the latter. Further balkanization of States that do and do not have workaround statutes would tend to enlarge the gap by further reducing the effective tax rate for high-income earners in high-tax States, without commensurate rate relief for otherwise similarly situation residents of States without workaround statutes. There may also be constitutional objections to these State statutes that end-run the Federal tax system with often no other substantive economic effect on the State level. Workaround statutes may alleviate concerns of Federalism and double-taxation, but no better than repeal would. It’s hard to make the case that workaround statutes make for better policy than repeal.
These issues present a conundrum for the Democratic Party. If the party wishes to continue its battle against the SALT deduction cap, it may be preferable to legislatively repeal the cap (and try to mitigate the regressive qualities of the SALT deduction as part of how the repeal is structured), than to back a more regressive patchwork of workaround statutes at the State level. But, more fundamentally, this may be an inflection point for the party to pause and reconsider whether this is a battle it should even be fighting.