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December 8, 2017

Another way states can counter a partial repeal of the SALT deduction

(This expedient could possibly even improve state public finance in the long term.)

By Darien Shanske

[Cross-posted from Medium.]

There have been numerous important discussions of how states might respond to the repeal of the SALT deduction. David Kamin lists some of them here; he also notes that these possible (likely?) responses should be taken into account by the JCT because they will reduce the revenue gains that the federal government is expecting.

I should like to sketch out one additional state response. Suppose the House approach to the SALT deduction were to become law. This means that the deduction would be eliminated except for $10,000 in property taxes. A certain group of taxpayers will now find themselves with less than $10,000 in property taxes to deduct, but lots of state income taxes that they can no longer deduct. To be specific, suppose a taxpayer has $5,000 in property taxes that they can still deduct, but $8,000 in income taxes that they cannot. If $5,000 of the income tax liability could be shifted into the property tax then the taxpayer (and the state) would not be leaving a deduction on the table. This could be done, of course, just by increasing property taxes and reducing income taxes. As it turns out, even if increasing property taxes is on balance a good idea, it is one that is highly fraught politically and has big implications for state-local relations. Also, as the current experience with drive-by tax reform is continually illustrating, major changes to tax systems should not be done quickly. See here for some of the issues raised by a shift to property taxes.

But a state with an income tax need not engage in a prolonged debate about increasing its property tax in order to maximize the value of the SALT deduction for its citizens. In broad strokes, all a state needs to do is formally increase its property taxes so that citizens can get the maximum deduction, but then in effect hold taxpayers harmless by means of the state's income tax.

Here is what this might look like a little more specifically. The state can authorize its localities to impose a special property tax supplement up to $10,000 so as to assure all taxpayers maximize their SALT deduction (if they end up itemizing). Next, the state creates a generous property tax circuit breaker in its income tax. The circuit breaker could work like this: to the extent the property tax burden as a percentage of a taxpayer's income is greater than it was in 2017 - and that increase is a result of a special supplemental property tax - then that additional property tax is forgiven. To be sure, there would be many details to work out (such as coordinating the timing of local property tax collection with the state income tax), but I think the mechanism is sound. An additional refinement could be to make certain that some small portion of the new property tax is in fact collected by the locality so that the whole structure is respected.

I should add that I believe that states (really localities) should increase their use of the property tax in general and that generous circuit breakers are an important way to make this possible. See my argument here. One would hope that the fact that this self-help proposal for the states is also a reasonable idea on its own would make it more attractive.