The smart tax-reform idea aimed at Democrats that will also rile Republicans

"America First"
"America First"

As US president Donald Trump and congressional Republicans begin their push to radically change the way Americans are taxed, they come armed with one very good idea, simplifying the tax code, and one very bad one, cutting taxes for the wealthy.

The Republican proposals include provisions that would lead to huge reductions in taxes paid by the wealthiest Americans—an estimate from the non-partisan Institute on Taxation and Economic Policy suggests the top 1% of earners would receive 60% of the cut. The argument for such cuts is not compelling. Wealthy Americans already pay less than their counterparts in other developed countries, and there is little evidence that lowering their taxes increases economic growth in a way that helps the broader populace.

Still, there is every reason to simplify the American tax system. Companies and individuals paying taxes in the US face a baroque system of loopholes and deductions that create perverse incentives. Republican proposals include a number of good ideas on how to fix this.

Passing up the SALT

One of the most interesting proposals is getting rid of the federal deduction for state and local taxes, and using the savings to lower individual rates. Repeal of the state and local taxes (SALT) deduction is part of a House Republican proposal. Along with the deduction for charitable gifts and mortgage interest, SALT is one the largest deductions offered to individuals. The non-partisan Tax Policy Center estimates the deduction will cost the federal government $96 billion in 2017, and $1.3 trillion over the next 10 years (and this might be an understatement).

A little less than 30% of Americans claimed the SALT deduction in 2014, and the beneficiaries tend to be wealthy—the Tax Policy Center estimates that nearly half of its benefits go to households with annual incomes over $200,000.

When most Americans do their taxes, they choose to accept the standard deduction. In 2016, it was $6,300 for unmarried individuals without dependents. But high earners, who pay large amounts in mortgage interest, give to charity, or pay lots in local taxes, often itemized deductions, because they total more than $6,300. This is why, even though the highest-income Americans are supposed to pay 40% of their income above $400,000 to the federal government, they actually pay a lower effective tax rate. The right-leaning Tax Foundation estimates that a repeal of SALT would lead to no loss of after-tax income for the bottom 20% of households in income, but a 2.1% loss for the highest-earning 20%.

The impact of getting rid of state and local tax deduction by income

Household income percentile Average change in after-tax income
0-20% 0.0%
20-40% -0.1%
40-60% -0.3%
60-80% -0.7%
80-100% -2.1%

Proponents of the SALT deduction say that it is a useful subsidy for local government. It makes high state and local income taxes for wealthy constituents more politically palatable. Without it, there would be pressure to lower those taxes, ultimately leading to a revenue crisis for local government.

Politics are less high-contrast than the map

Critics of SALT argue that if the federal government wants to subsidize state and local governments, simply supplying grants is more efficient. There would be federal oversight over how that money was spent, and it wouldn’t disproportionately benefit states that choose to have high taxes. Also, the money saved could be used to lower individual income tax rates across the board, which should partially mollify high-income earners.

Notably, the beneficiaries of the SALT deduction are disproportionately located in states that voted for Hillary Clinton, and generally lean Democratic. Blue states tend to be wealthier and usually have higher local taxes. For example, about 40% of households in New York state benefit from the deduction, compared with less than 20% in Texas, which has no state income tax. In fact, the Tax Policy Center’s Frank Sammartino points out that just two deep-blue states, California and New York, account for almost one-third of deductions claimed.

Blue-states-benefit-more-from-the-state-and-local-tax-deduction_mapbuilder (1)

The fact that removing the SALT deduction hurts Democratic-leaning states more than Republican ones is part of what might make it politically feasible for Trump and congressional Republicans. Still, states are not fully blue or fully red, and there are lots of Republican lawmakers in Democratic states. Many of these Republicans have condemned the idea of repealing the deduction—a number of congress members from New York and New Jersey even signed a bipartisan letter to Treasury Secretary Steve Mnuchin asking that the deduction be retained.

If tax reform is passed, and a change to SALT is part of it, expect it be a cap on the amount of the deduction rather than a total repeal.

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