Blue-State Republicans Seek to Soften State Tax Deduction Cut

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By Laura Davison and Che Odom

Eliminating the state and local tax deduction is one of the leading revenue raisers under consideration for a tax reform bill, but there is a push among congressional Republicans from high-tax states to mitigate the effects of axing that benefit.

Some Republicans are privately looking for a way to replace the deduction with a less costly credit or to cap the deduction, preserving some of the tax break while still raising revenue that can be used for tax reform, a GOP aide said.

The effort is largely seen as a last-ditch attempt to salvage some of the time-honored deduction’s benefits, because the state and local tax (SALT) deduction being used as a pay-for is a foregone conclusion at this point, said the aide, who asked to remain anonymous because they weren’t authorized to speak about internal deliberations. Lawmakers are also fighting to keep tax benefits that cities like, such as the tax exemption for municipal-bond interest, as a way to soften the blow for city and state governments that would be pressured to lower taxes if the deduction is eliminated.

Other large revenue raisers floated by congressional Republicans, such as the border adjustment tax and elimination of interest deductibility, have been tabled or have failed to generate traction within President Donald Trump’s administration. That leaves the SALT deduction, estimated to raise between $1.26 trillion and $1.9 trillion over a decade by the Urban-Brookings Tax Policy Center and the Tax Foundation, respectively.

State, Party Lines

The compromise under consideration highlights the inherent difficulty in tax reform. The divides over which provisions can be tapped for revenue aren’t partisan ones, they’re geographical. The deduction is worth more to high-tax New York and New Jersey residents than it is to people living in low-tax North Dakota or Indiana. The idea of a credit as a compromise was first reported by the New York Post.

New York Republicans, including Reps. John J. Faso, Peter T. King, and Dan Donovan, sent a letter to Treasury Secretary Steven Mnuchin in June asking him to reconsider his position on eliminating the deduction.

The letter said about 3.2 million New Yorkers claim the deduction and that 85 percent of those who claim it make less than $200,000 annually, addressing a common criticism of the deduction that it is primarily used by wealthy taxpayers.

One option lawmakers could consider is converting the deduction to a 15 percent credit, Kyle Pomerleau, director of federal projects at the Tax Foundation, told Bloomberg BNA. That redistributes the benefit of the tax credit, making it available to middle-income taxpayers that don’t currently have access to it and making it less valuable for high earners.

Replacing the deduction with a credit would raise $137 billion over a decade, according to estimates from Pomerleau—a far cry from the $1.9 trillion he estimates for a full repeal of the deduction.

Adding a “floor” to the credit, such as allowing taxpayers to take the credit for amounts over the first $1,000 paid in state and local taxes, would raise more money for the government, Frank Sammartino, a senior fellow at the Tax Policy Center told Bloomberg BNA. With a 15 percent credit, that could raise $235 billion over a decade.

“With a credit you create winners who can now claim the credit because they don’t itemize, but that will eat away at the revenue savings,” Sammartino said. Changing the rate of the credit and the floor can affect how much it raises, he said.

Deduction Options

Instead of instituting a credit, lawmakers could limit the deduction. Doing so wouldn’t make it available to taxpayers who don’t itemize, but it could raise more revenue than a credit would. Limiting the deduction to $6,000 would raise $870 billion over a decade, more than three times what the credit is projected to do, Sammartino said.

Adam Michel, a policy analyst at the Heritage Foundation, said the SALT deduction should be eliminated as a matter of good tax policy and simplification.

“Tax credits have the same problem where they introduce complexity and open the code to additional sources of privilege,” he told Bloomberg BNA. “A tax credit should only be used to subsidize a beneficial activity.”

Groups Wary

As lawmakers and economists consider the policy options, groups representing state and local governments are fighting for the deduction’s survival. In an April letter to Congress, seven organizations—including the National Governors Association, the U.S. Conference of Mayors, and the National Conference of State Legislatures—said that eliminating or capping “federal deductibility for state and local property, sales and income taxes would represent double taxation, as these taxes are mandatory payments for all taxpayers.”

While these groups aren’t eager to suggest ways to structure a tax credit to replace the deduction, the idea of a credit could be tolerable for some of them, depending on the details.

“We have only just begun to consider how a tax credit would be applied in lieu of the deduction,” Max Behlke, budget and tax director of the National Conference of State Legislatures, told Bloomberg BNA. “Therefore, until the concept is fleshed out with additional details, I cannot comment on whether or not we would support or oppose it.”

A tax credit that provides more of a benefit to lower- and middle-income taxpayers, though a compromise move away from the current system, still may never be popular with states and cities with relatively high taxes, Alan Auerbach, an economics and law professor at the University of California, Berkeley, told Bloomberg BNA.

“I suspect that it will meet with a negative response from high-tax states like California, just as full elimination of the tax benefit would,” said Auerbach, who has written extensively about tax policy and reform efforts in Washington. “I imagine that the hope of those proposing it is that they can sway some who are on the fence about full elimination.”

Something Has to Give

Ending deductibility, even replacing it with a credit, may simplify the tax code—but to the detriment of New York, New Jersey, and California, as well as other high-tax states, according to E.J. McMahon, president of Empire Center, a conservative-leaning tax policy group.

“State and local taxes have always been deductible,” McMahon said. “The first federal income tax that was temporary during the Civil War had deductibility in it.”

Republicans have a long list of tax changes they would like to make, and many of them, such as cutting corporate and individual rates sharply and giving businesses a more generous expensing allowance, are expensive. With several large revenue raisers off the table, the SALT deduction is one of the most attractive options to many GOP lawmakers.

“Preserving this benefit as a credit may protect some taxpayers and may make some parts of the tax code more progressive,” Pomerleau said. “But something has to give somewhere. If this isn’t the thing that has to give, you’re not going to be able to get some other stuff that people think is important in tax reform.”

To contact the reporters on this story: Laura Davison in Washington at lDavison@bna.com; Che Odom in Washington at COdom@bna.com

To contact the editor responsible for this story: Meg Shreve at mshreve@bna.com

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