OverTraders.com is your home for comprehensive analysis of today’s financial markets. In this piece we’ll explore how State and Local Tax (SALT) deduction changes could shape political fortunes ahead of next year’s mid-term elections, focusing on key demographics and states.
Understanding the State and Local Tax Deduction (SALT)
The State and Local Tax (SALT) deduction political and economic firestorm has joined those ranks. This is an important topic to address, as it has a significant impact on both taxpayers and the revenues states receive. So knowing the mechanics and history of this deduction is key. It can have a lasting influence on the outcome of future elections and policy decisions.
Definition of the SALT Deduction
The SALT deduction lets taxpayers lower their federal taxable income by deducting the cost of specific state and local taxes they’ve already paid. These can include property taxes, income taxes, and/or sales taxes. Before the 2017 Tax Cuts and Jobs Act (TCJA), taxpayers were allowed to fully deduct these taxes. This would have been a powerful step towards equity except that the TCJA added a cap of $10,000 per household on how much SALT could be deducted. This change disproportionately impacted taxpayers living in states with high state and local taxes. New York, New Jersey, California, and Illinois bore the worst brunt.
How the $10,000 cap was put into practice has been the subject of much controversy. Supporters of the cap claim that it helps to make the federal tax code more progressive. They argue that it is an unjustified limit on a deduction that mostly went to higher-income households in mostly wealthier states. Opponents make the case that the cap disproportionately punishes individuals residing in states with generally higher tax rates. Reviewing concerns, they think it’s double taxation because these folks are already paying state and local taxes. The cap is currently set to end after 2025. Importantly, several other provisions of the TCJA, such as the doubled standard deduction, will similarly sunset, setting the stage for legislative wrangling and political gamesmanship.
Benefits for Taxpayers
Prior to TCJA, the vast majority of households experienced an enormous tax subsidy from the SALT deduction. This hit hardest on those who resided in states with high property taxes and state income taxes. By claiming these taxes as deductions from their federal taxable income, taxpayers were able to reduce their federal tax liability. This turned out to be particularly advantageous for itemizers—those who elect to write off certain expenses rather than take the standard deduction.
The SALT deduction was not a progressive benefit to begin with. Higher-income households are more likely to own high-cost homes and therefore pay more in state income taxes. Consequently, they typically receive a greater benefit from the deduction’s tax subsidy. This provision has been the focus of vicious partisan criticism over the fairness and equity of the SALT deduction. Critics charge that the plan will further enrich the well-connected few. Despite the cap, the deduction is still a scarce source of relief to taxpayers. Its potential repeal or modification sets off a firestorm in tax policy circles.
Consequences of Removing the SALT Deduction (2017)
Adding the $10,000 cap on the SALT deduction, imposed in 2017, heightened the stakes for individual taxpayers. It has most definitely upended state revenues and changed the political landscape dramatically. These sort of impacts are key to understanding the possible implications of any future SALT deduction modification.
Economic Impact on Taxpayers
The $10,000 cap on the SALT deduction has very real effects on taxpayers. This effect is particularly acute for people who live in high-tax states. Households that had previously itemized deductions were suddenly stymied by the cap. It limited their ability to offset their federal tax liability, leading to increased tax bills. This effect was most pronounced for middle- and upper-middle-class families in states with high property taxes and state income taxes.
Earlier this month, the Tax Policy Center (TPC) released an analysis that focused on the distributional effects of repealing the SALT cap. Their analysis showed that the clear winners of any repeal would be the top income earners. As noted by the Tax Policy Center here, about 43 percent of the benefit from lifting the cap would go to high-income households. Hopefully, this analysis will shed light on the regressive nature of the SALT deduction, which primarily benefits more affluent taxpayers.
Joint Committee on Taxation (JCT) data provides additional context to demonstrate the fiscal cost of the SALT deduction. In 2017, prior to full implementation of the TCJA, SALT deductions accounted for an estimated $100 billion in reduced federal revenues. By 2019—after the cap went into effect—this number fell to $21 billion. The JCT further projects that SALT deductions will continue to lower federal revenues by roughly $21 billion per year through 2026. The cap on the state’s SALT deduction is scheduled to expire in 2026. Thus, the JCT estimates that SALT deductions will cost revenues $139 billion. This new projection highlights the tremendous fiscal weight of the SALT deduction, with enough flexibility to fundamentally alter the shape of federal tax revenues.
At the same time, the JCT predicts a significant rise in the share of itemized deductions relative to taxable income. In 2023, the value of itemized deductions is expected to be about 5 percent of taxable income, or $749 billion. By 2026, this number is projected to increase to almost 14% of taxable income, or $2.4 trillion. One big reason for the dramatic spike is the removal of the SALT cap. Under current law, taxpayers have much greater flexibility in deducting state and local taxes.
Changes in State Revenue and Budgeting
Foes of the SALT cap say that its imposition has had deeply damaging impacts on state revenues, budget-setting and more. Now some of the states, particularly those already saddled with excessive state and local taxes are howling. They are making the case that the tax cap is damaging their economic competitiveness by driving up the cost of living and working for their residents. They claim that the cap has made such states unattractive. This would have the unfortunate effect of forcing New Jersey residents and businesses to flee to lower-tax states.
In response to the SALT cap, many states enacted different strategies to reduce its negative effects on their residents. These strategies include:
Some states have enacted legislation to allow taxpayers to make charitable contributions to state-run funds in lieu of paying certain taxes, with the understanding that these contributions would be deductible for federal tax purposes. The IRS has disputed the legality of at least some of these workarounds.
Reducing state taxes: Some states have considered or implemented cuts to state income or property taxes in an effort to offset the impact of the SALT cap.
Lobbying for repeal or modification of the cap: Many states and local governments have actively lobbied Congress to repeal or modify the SALT cap, arguing that it unfairly burdens their residents and undermines their ability to fund essential public services.
The future of the SALT deduction is sure to be hotly contested in the months leading up to the 2024 elections and after. Democrats have almost universally supported repeal or an increase of the cap, citing its disproportionate impact on middle-class families in states with relatively high taxes. The confusion among Republicans runs deep on this point. On one side are those who support the cap to rein in out-of-control federal spending and make the federal tax code more progressive (increased reliance on higher income earners, decreased reliance on lower income earners).
The SALT deduction continues to be a controversial issue with major consequences for taxpayers, state coffers, and the political scene. Make sure you stay tuned and follow OverTraders.com for more coverage and analysis on this critical issue as it develops.
