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December 8, 2017

I attempt a principled defense of the House approach to SALT repeal

(Spoiler Alert: I fail)

By Darien Shanske

[Cross-posted from Medium.]

The tax reform plan that just passed the House of Representatives repeals the SALT deduction, except for $10,000 in property taxes. The Senate plan would repeal the deduction outright, though there appears to be a chance that the final Senate bill will move closer to the House position. Numerous commentators have weighed in on both plans and, in general, the consensus is that neither plan is very well conceived. There are at least three main lines of criticism, all of which I largely agree with. First, per Daniel Hemel (and many others), on basic income tax principles there is a sound argument that some portion of the deduction should be maintained for individuals because these taxes do not pay for personal consumption, and so the Senate plan simply fails on that ground. There is also a good argument that the deduction is justified for businesses, though note that retaining the deduction for businesses but eliminating it for individuals leads to incentives for individuals to take the SALT deduction at the business level. Perhaps, as David Kamin explains, this problem has now been addressed, though, as he also notes, the current legislation does not take into account numerous possible responses by the states to eliminating the individual deduction.

Second, as to which set of taxes - state or local - have the better claim to be retained as a deduction on income tax principle, the better argument is for state income taxes and not property taxes, which are typically local. This is because, as Gladriel Shobe has argued here and here, there is a stronger argument that local property taxes are prices paid to consume local amenities rather than state level taxes. The House proposal therefore gets matters backwards from an income tax principle (and distributive) perspective.

A third important critique is to note that eliminating the deduction, when combined with other aspects of the Republican plans, amounts to a tax increase specifically targeted to certain parts of the country. This is just not good for our polity.

But can anything positive be said about this? I can almost make an argument in favor of the House approach as to the property tax. That I can't in the end illustrates, in yet another way, the incoherence and meanness of these proposals. Back in 2012, I argued that there was a good argument for the federal government to repeal the SALT deduction except for the property tax component. My argument was not based on income tax principles, but on the proper role of the central government in a federation. One of those roles is maintaining stability and generally optimizing the revenue system of all of the component governments. It is axiomatic that the property tax is a relatively efficient tax that should be assigned to local governments to finance local public goods. The forty years since California's Proposition 13 has also made it clear that states and localities were reducing their reliance on the property tax - in part because of the liquidity problems commonly associated with the tax. There was therefore, I thought, a good argument that the federal government should intervene to make the property tax relatively cheaper so as to nudge its continued - or even increased - use.

The current House proposal bears some resemblance to what I had in mind and yet I still think the House proposal is not a good idea. Why? For one thing, from the perspective of 2017 I realize that my argument missed at least two big points. First, my underlying assumption was that the federal government would be continuing to carry out another of its key roles - redistribution. Eliminating the SALT deduction in order, in part, to pay for the ACA, or at least prevent cuts to the ACA and other social insurance programs, seemed reasonable distribution-wise in 2012. Indeed, I argued that encouraging the use of the relatively stable property tax actually benefits the less well-off precisely because, as David Gamage has shown, they are the ones most likely to suffer from sharp state and local budget cuts during a recession.

By contrast, in the current context, the proposal is to eliminate or reduce the SALT deduction as part of a spectacularly regressive tax reform proposal that is part of a still broader attempt to sharply reduce the role of the federal government in taking care of the less fortunate. Making it more difficult for the states to care of the very people that the federal government is abandoning - or trying to abandon through, for instance, dismantling the ACA - is deeply wrong. (If we were in the midst of a deep recession, then there would be an independent argument for a fiscal stimulus, but this is not the case.)

In 2012, I also underestimated state resilience (not everyone did). Back then it seemed that California, for example, would not, as a matter of politics, increase its state-level income and sales taxes and, even it could, I didn't think enough could be raised to right the ship. But California did raise its income tax twice, and in a progressive way, and the state currently has built up a significant rainy day fund. Without doubt, California still has fiscal challenges and it would be much better for the state to rely more on the property tax, but I was wrong to think that this was the only way forward. In short, I overestimated the problem to which my proposal was a solution.

In any event, if the House plan were serious about reviving the property tax on fiscal federalism grounds, it would not proceed by means of preserving the deduction in the way that it does, especially in the context of a plan that also doubles the standard deduction. As an itemized deduction that is only worth anything beyond the new larger standard deduction, there is unlikely to be much shift in state or local political economy under the House plan. A way to achieve such a shift would be to make a portion of the property tax an above-the-line deduction, as it was briefly in 2008-09. Though still problematic for the reasons noted at the outset, that would at least represent a coherent - and less regressive - choice to advance a policy goal through advantaging the property tax. Needless to say, I do not expect this to happen.