Republicans on the House Ways and Means Committee have proposed three tax bills under the umbrella titled “American Families and Jobs Act.” It’s impossible to do a comprehensive analysis in this short article. Instead, I focus here on one good thing: it keeps the State and Local Tax (SALT) limit, a key feature of the 2017 Tax Cuts and Jobs Act.
The SALT limit caps the amount of state and local tax that taxpayers can claim if they itemize their deductions. The cap is $10,000 annually for individual taxpayers and for married taxpayers filing jointly. Before the 2017 tax cut law, taxpayers who itemized faced no limit on the amount of state and local tax they could deduct. The change meant that high-income taxpayers who live in states with high income taxes took a huge hit. Even so, most taxpayers gained at least a little because the standard deduction was raised substantially to make up for the SALT limit, and marginal tax rates were cut somewhat for the vast majority of taxpayers.
Of course, politicians from high tax states like New York and California don’t like the SALT limit. So why do I think it’s so good?
This is from David R. Henderson, “Don’t Trade SALT for Broccoli,” TaxBytes, Institute for Policy Innovation, August 3, 2023.
Read the whole thing, which is short.
By the way, I love broccoli. I’m using broccoli to stand for higher tax rates because my impression is that many people hate broccoli.
READER COMMENTS
Dylan
Aug 5 2023 at 10:50am
Your headline got me! I too love broccoli, and was trying to figure out what crazy broccoli subsidies House Republicans were trying to cram into a tax bill.
Side note: I bought broccoli for the first time in a couple of months yesterday. I’d stopped because the price had gone up to around $7 a bunch, and they were smaller and lower quality at that. Yesterday, I noticed the price was back down to $2.50 and the quality looked much better.
robc
Aug 5 2023 at 3:24pm
The SALT deduction causes and internal conflict that I cannot resolve.
On the one hand, I prefer getting rid of as many deductions as possible, so would like to see SALT undeductible.
On the other hand, I think all parts of the tax code should be indexed to inflation and not create a marriage penalty. And the SALT limit violates both of those.
So I want it raised (doubled for married plus adjusted for inflation) and eliminated.
robc
Aug 6 2023 at 11:24am
Just to be clear, not allowing SALT deduction satisfies all 3 of my conditions. So that is the best approach. But limiting the deduction to a number greatly than $0 violates 2 of them.
steve
Aug 5 2023 at 6:10pm
“The greater the portion of our additional income we can keep, the higher is our incentive to make more money. ”
Except if you live in NY or CA.
Steve
David Henderson
Aug 5 2023 at 10:17pm
No. It applies to New York and California also. Incremental incentives work everywhere.
nobody.really
Aug 6 2023 at 2:59am
I’m astonished. This must be the first time I’ve observed David Henderson acknowledge that ANYTHING works in New York and California. 🙂
Thomas L Hutcheson
Aug 5 2023 at 9:27pm
I am puzzled by the objection to the SALT deduction. If the objective of tax reform is to make the income tax more of a consumption tax (something I though conservatives, libertarians and neoliberals agreed on), allowing full deduction for SALT, which is not the taxpayer’s consumption, seems reasonable. Is it just political to encourage higher income people to push harder against state and local taxes?
MarkW
Aug 6 2023 at 11:26am
Here’s a thought experiment. Imagine you lived in a town that consisted of just your own family. Then imagine you voted for extraordinarily high property taxes to fund lavish ‘public’ services for your town’s citizens and were able to deduct those ‘taxes’ and the cost of the services from your income and pay no federal tax on it. That’s effectively what some extremely high tax states and localities were doing. It’s conceptually similar to when executive used to enjoy tax free company cars, club memberships, etc.
BC
Aug 6 2023 at 12:33am
Besides nutrition, broccoli is useful for hypotheticals and thought experiments when considering the appropriateness of various policies. For example, suppose New York required its residents to buy a certain amount of broccoli each year. Should those broccoli purchases be deductible on federal income taxes? I don’t see why they should. Why should other states residents have to subsidize New York’s mandates? If mandated broccoli purchases shouldn’t be deductible, then why should mandated state taxes? After all, New York could use those state tax dollars to buy broccoli for its residents. Then, making New York state taxes deductible would be equivalent to making mandatory broccoli purchases deductible.
“That deductibility gives those governments an incentive to do more spending, much of which is wasteful…” For example, those governments might spend a lot of money buying broccoli.
Scott Sumner
Aug 6 2023 at 12:54am
Good points. The SALT limit is one of the few good things to have come out of Washington in the past decade. Sad to see people working to reverse that gain.
vince
Aug 6 2023 at 4:16pm
SALT has been knee-capped by high-tax states in a legalized tax fraud scheme. It’s called the pass through entity tax election. It’s a fraud that Democrats used to bypass the SALT while not appearing to give a tax break to the wealthy. Congress wouldn’t pass it and take the criticism. As soon as Biden was elected, the IRS officially condoned the fraud. It works like this:
An entity that issues a K1 pays a voluntary state tax. The IRS allows the tax deduction to pass through to the owner as a business tax, escaping the SALT limit. The state gives a refund to the owner for that same tax payment. In other words, the owner pays nothing but gets the state tax deduction.
In any other situation, that refund would be taxable. It’s called the tax benefit rule–if you take a deduction and get a refund, the refund is taxable income. The IRS has decided to ignore that longstanding rule–like they ignored the tax evasion of Hunter Biden, who failed to report $400,000 in taxable income in 2014 but escaped when the IRS intentionally ignored it until the statute of limitations expired. The media is silent about both frauds.
David Henderson
Aug 6 2023 at 6:33pm
Wow! Thanks, Vince.
BC
Aug 6 2023 at 11:35pm
If I understand correctly, *personal* SALT deductions are capped but not pass-through entity (PTE) business SALT deductions that are passed through to owners. So, these states are converting *personal* state income taxes to PTE *business* state taxes, which are fully deductible. For every dollar that a PTE pays in business state “elective PTE” tax, the owner’s personal state income tax liability is reduced by a dollar. (Some states like MA reduce personal state income tax by only 0.90 for each dollar.) It’s not a refund to the owner of the *business* tax paid; it’s a credit reducing the owner’s *personal* state income tax liability. That’s why the tax benefit rule isn’t kicking in.
Congress could presumably close this loophole by limiting deductions on business SALT on PTEs to match limits on personal SALT. However, that might impact the deductibility of “legitimate” business SALTs. Also, of course, the current Congress and President might be less willing to limit SALT deductions than the 2017 Congress and President.
Vivian Darkbloom
Aug 7 2023 at 4:08am
Yes and no. As is frequently the case, the answer to the issue is complicated and, in this case, unsettled.
It is possible that the business deduction allocated to the partner due to the 9.3 percent California tax payment is greater than the actual state tax ultimately due on that same partner’s CA return. The partnership level tax gives the partner a (refundable) *credit*, (not a deduction) against CA state tax. Thus, in those cases where the actual CA tax is lower than the allocated partnership level tax, a refund will effectively ensue.
AFAIK, the issue of whether that refund results in taxable income for federal tax purposes is not settled and the answer may depend on the specific mechanics of each state PTE scheme. There is a good summary of the issues surrounding the PTE state laws at Tax Notes, here:
https://www.thetaxadviser.com/issues/2022/nov/federal-implications-passthrough-entity-tax-elections.html
There are several unsavory aspects of the PTE laws (22 states have them). These PTE schemes are specifically designed to thwart the federal SALT deduction limit and, in fact, the CA statute is scheduled to sunset at exactly the same time as the federal law (2025). Also, this scheme not only benefits solely those with high incomes, but only a subset of those high earners, such as the Feinsteins and the Pelosi’s.
BC
Aug 7 2023 at 10:50am
Agreed that these PTE laws are more than unsavory, whatever one thinks about SALT deductions. Many of them, not just CA, are explicitly tied to the federal law and disappear when the federal SALT cap does. State legislatures aren’t supposed to have the power to modify federal tax laws for their own residents (supremacy clause). FL isn’t allowed to pass a law that says its residents are exempt from paying federal capital gains tax, for example. Of course, someone from the federal govt (IRS, Justice Dept, etc.) or someone else with standing would actually have to challenge these state provisions…
BC
Aug 7 2023 at 11:39am
“whether that refund results in taxable income for federal tax purposes is not settled”
If the refund portion, the portion in excess of actual state tax liability, were not taxable federal income, then wouldn’t that allow a state to effectively lower its residents’ federal tax, apart from any SALT cap? For example, the PTE could pay an elective state tax equal to the owner’s entire taxable federal income and the state could offset that through a refundable state tax credit to the owner. The PTE passes through the business tax deduction to the owner. If the refund part of the state tax credit were not taxable federal income, then the owner’s federal taxable income would be zero?
Btw, this seems like a great argument for why no SALT should be deductible. When states use taxes to provide benefits for residents (instead of returning the taxes as refundable credits), those benefits typically are not taxable federal income. For example, the fair value tuition at public schools is not taxable income to the parents. Normally, when one buys broccoli for one’s own personal consumption, one can’t deduct the broccoli expenses from federal taxable income. If a state has a “free” broccoli program, however, where it uses residents’ taxes to buy broccoli and gives the broccoli back to residents (“refunds the taxes as broccoli”), then the fair value of the broccoli benefit is not taxable. So, if SALT is deductible, then residents effectively get to deduct their broccoli expenses. SALT deductions incentivize states to socialize broccoli and everything else.
robc
Aug 7 2023 at 12:20pm
I think this is a good example of why the income tax is a bad idea.
“What is income anyway?” is a very legitimate question.
Three of the Four progessive era amendments were really, really bad ideas.
vince
Aug 7 2023 at 12:34pm
robc asks: “What is income anyway?”
Income is defined as any accession to wealth unless specifically excluded by Congress. That also would make the credit from this scheme taxable as income.
Vivian Darkbloom
Aug 7 2023 at 12:59pm
I think your reasoning is correct and for this reason the (much) better argument is that any refund at the taxpayer level should be taxable for federal (and presumably state) tax purposes.
An individual taxpayer and/or his adviser could likely be charged with criminal fraud if a scheme were to be carried out in which there is no business purpose other than tax reduction. “Business purpose”, “substance over form”, etc., are common tests to reject the legitimacy of tax reduction schemes. Our politicians are often hold themselves to a lesser ethical standard than the citizens whose interests they supposedly represent.
The IRS Notice referenced in the article I linked to was issued in November 2020; that is, during Trump’s term. It goes to show, I guess, that the President doesn’t control everything that occurs under his watch, particularly, in this case, the IRS.
vince
Aug 7 2023 at 2:16pm
Yes, it was issued during Trump’s term, but just days after he lost the election. That’s why he calls it the Swamp, Deep State, and so on.
robc
Aug 7 2023 at 3:35pm
My question was more about a platonic ideal of income, which shouldnt require a reference to congressional acts. The fact that income depends on congressional definition is my point, it overcomplicates the situation.
There would be a similar, but lesser, problem with a consumption tax.
A land tax doesn’t have that problem, but it does have a valuation problem. Which still is less bad of an issue than the others.
vince
Aug 7 2023 at 12:30pm
It’s irrelevant whether the recovery is called a credit or a refund, or whether it’s a business tax or a personal tax. The tax benefit rule applies to recoveries of prior deductions (to the extent a benefit was received for the deduction). The deduction is taken on the owner’s personal return, and the recovery is received by the owner. The article linked by Vivian Darkbloom says this:
“Some practitioners have argued that Sec. 111 does not apply with respect to SITPs because the taxpayer claiming the deduction (the PTE) and the taxpayer receiving the refund (the partners or members) are not the same. However, in similar circumstances the courts have ruled otherwise.”
And that’s a situation not as obvious as this one, in which the taxpayer receiving the deduction and claiming the recovery *are* the same. This is a pass through deduction to the owner’s tax return.
There are many other longstanding tax principles that this scheme violates. A very simple one is that a business expense is not allowed as a tax deduction unless it’s considered ordinary and necessary in carrying on the business activity. Without that law, a business could easily eliminate its taxable income. An optional tax, by definition, is not an ordinary and necessary business expense.
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