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Commentary: States Are Trying to Fix the New Tax Bill. But They Might End Up Making It Worse.

Steve Wamhoff

Two wrongs don’t make a right. But some state officials, incensed by the new federal tax law’s $10,000 limit on deductions for state and local taxes (SALT), appear to have forgotten this sage advice and are considering proposals to help their residents avoid these limits.

In their rush to work around the federal law—called the Tax Cuts and Jobs Act—state lawmakers could make an already unfair and complicated tax system even more so. By narrowly focusing on the $10,000 SALT cap, state lawmakers are pursuing an economic fix for the very taxpayers who will benefit most from the federal tax bill. Proposals released so far are aimed at allowing these taxpayers to keep their income and property tax deductions by transforming them into something else.

One proposal would replace state income taxes with an employer-side payroll tax. While individuals can no longer deduct unlimited state and local taxes, employers can still deduct all payroll taxes they pay on behalf of their employees. The general idea behind this fix is that employers would reduce salaries to offset their payroll tax payments, but workers would not have to pay state income taxes. Their lower take-home pay would result in a lower federal tax bill. The after-tax income of state residents would, the argument goes, be the same as under the old federal tax law.

This approach presents many practical problems. First, it’s a policy that would rely on the good will of employers to evenly implement pay changes. When an employer reduces pay to offset its payroll tax increase, it could focus on workers who have less bargaining power—typically those with low wages and benefits to begin with. Another practical issue is that a payroll tax wouldn’t affect all income. Investment income that mostly flows to the richest households, such as capital gains and stock dividends, is usually subject to state income taxes. It would be impossible to tax this kind of income via a payroll tax. Finally, many states provide an earned income tax credit (EITC) that is extremely important in fighting poverty, and this too would be more difficult to implement under a payroll tax system.

To be sure, some hybrid ideas have emerged that would partially retain the personal income tax and replace just some of the revenue with a payroll tax. But this would add a great deal of complexity to the tax system in order to make changes that, from the perspective of the states, do not improve fiscal health at all but merely substitute one type of revenue for another.

A second proposed workaround would turn state and local taxes into a credit for “charitable contributions” made to state and local governments. A taxpayer’s total payments would be unchanged because their state taxes could be reduced by the amount they “contributed.” But taxpayers would, the argument goes, be allowed to fully deduct the amount on their federal tax returns because the new law still allows most charitable giving to be deducted for federal tax purposes.

But the Internal Revenue Service could and should block this approach. A state government is not a charity. This workaround would violate the basic rationale for charitable deductions, which is that money given to charity does not benefit the taxpayer but society generally. In fact, taxpayers are even required to reduce their charitable deductions by any amount that benefits them personally. If you make a $200 contribution to public radio and receive a coffee mug in return, you must reduce your deduction by the value of the mug. If states provide tax credits that wipe out state income taxes by an amount equal to a taxpayers’ “contribution” to state or local government, that obviously benefits the taxpayer more than a coffee mug.

And there is a deeper fairness concern about the hyper-focus on workarounds. As is widely known, the new GOP tax law will sharply reduce taxes on the best-off Americans while providing smaller (and, eventually, zero) tax breaks for middle- and low-income families. One of the few provisions that will meaningfully offset tax cuts for high-income families is the $10,000 SALT cap. If any of these state workarounds are successful, the overall impact will be to make an indefensibly unfair tax cut even more regressive.

A more sensible policy response would be to raise state taxes on the high-income residents who have just been given enormous federal tax cuts. The Institute on Taxation and Economic Policy estimates that the richest 5% of Americans will receive more than half of the benefits of the new federal tax law in 2019, and the richest 1% of Americans will receive more than a quarter of the benefits. Restructuring state tax systems in a way that takes back some of these high-end federal tax cuts should be a no-brainer for cash-strapped states. For example, New Jersey’s governor-elect, Phil Murphy, is moving ahead with his campaign proposal to raise taxes on the state’s millionaires.

Many state tax systems are also inadequate to address coming budget shortfalls or to finance the kind of investment necessary to offset the drop in federal spending that will inevitably follow Congress’s $1.5 trillion tax cut. Both of these problems could be partly solved if states claw back some of the tax breaks Congress just provided to those who least need them.

Steve Wamhoff is a senior fellow at the Institute on Taxation and Economic Policy.