Mises Wire

Why Biden Wants a Cap on State and Local Tax Deductions

When the Trump administration pushed capping the federal tax deduction for state and local taxes (SALT), the plan was billed as a way to punish Democrats in high-tax states. But the move also increased federal revenues by as much as $100 billion. Now the Biden administration is showing little enthusiasm for undoing Trump’s cap. The cap means more federal revenues to help pay for Biden’s infrastructure plan.

Nonetheless, Democrats in high-tax states like California, New Jersey, and New York are now threatening to hold up President Joe Biden’s plan in the hope of eliminating the cap on the SALT deduction. The SALT deduction divides the Democratic Party between socialist activists like Bernie Sanders and Alexandra Ocasio-Cortez, who oppose the repealing of the SALT deduction as a “gift to billionaires,” and other representatives of New York and New Jersey, who want an elimination of the cap. However, in the debate on whether SALT is a tax break for the rich or a lifeline for middle-class families in high-tax states, most politicians forget that a tax takes away money from an individual regardless of income. The cap on the SALT deduction also essentially paves the way for the federal government to tax income twice. 

The SALT tax deduction allows state and local taxes—like property taxes—to be deducted from federal taxes. State and local taxes and other taxes have been deductible since the inception of the federal income tax in 1913 to avoid federal encroachment on state tax prerogatives and to allow the federal government to tax income that has already been confiscated via taxation by more local levels of government. Changes in 1964, 1978, 1986, and 2004 have mostly taken away the ability to deduct certain state and local taxes, with the exception of the 2004 change, which reinstated the original ability to deduct sales taxes. However, the biggest change came in 2017, when the SALT deduction was capped at $10,000 under President Trump’s tax reform bill. However, that provision in the law is scheduled to expire after 2025.

Unfortunately, many conservatives argue in favor of the cap and claim that the SALT deduction benefits higher-tax states like New York, New Jersey, and California at the cost of those living in lower-tax states like Texas, New Hampshire, and South Dakota. The Tax Policy Center provides a good overview of who claims the SALT deduction and its effects. Similarly, the Tax Foundation provides an overview of benefactors of a SALT deduction and its consequences. Politicians use this discrepancy in impact to justify the elimination of the deduction on the grounds that it is an unfair subsidy to high-tax states.

However, most analysts seem to look at the consequences of the SALT deduction without looking at the reason for the SALT deduction: state and local taxes. Whatever one might think about the original federal income tax, at the least the original federal income tax statutes in 1913 answered two questions about the deductibility of state and local taxes quite clearly. The deduction was introduced to avoid federal encroachment on state and local tax prerogatives and, equally important, to avoid double taxation. The question that still needs to be answered is whether it is morally okay to tax income that isn’t really income at all, but funds that must be paid toward state and local taxes. Sure, progressives, socialists, and communists would like to take away as much money as possible from the rich, but it is problematic, to say the least, to tax income that is not even in the hand of a taxpayer anymore. That is, taxing funds already taken by state and local authorities is essentially taxing hypothetical income and earnings. This would be similar to taxing the paper value of an investment portfolio value instead of the realized gain from the sale of an investment.

The second argument for eliminating the cap on the SALT is that the cap grows the role of the federal government at the expense of more local levels of government. In other words, the SALT deduction lowers the amount of income to be taxed by the federal government, while imposing a limit on the SALT deduction is to increase federal revenue.

This is especially problematic, since federal taxes are already a major part of households’ overall tax burden. Moreover, federal taxation is less likely to go to services that taxpayers might actually use, such as highways. Federal spending mostly goes to welfare programs. Keeping the cap on the SALT deduction actually increases federal tax revenue and decreases decentralization. More importantly, any increase in federal taxes reduces the ability for taxpayers to “vote with their feet,” leaving high-tax states and localities for lower taxes in another state or locality. (See this article by Ryan McMaken.)

Some advocates for keeping the deduction cap—but who also claim to be for low taxation—argue that by exposing taxpayers in high-tax states to higher levels of taxation, taxpayers would finally come to their senses and revolt against state taxation. This is essentially a “do evil that good may come of it” argument. This is an odd position to take for anyone claiming to oppose government power and taxation.

The debate on the SALT deduction needs to be rephrased as a debate on the morality of taxing unrealized income. In addition, it is important to consider the repercussions of handing over more taxing authority to the federal government. While the uncapped SALT deduction reduced tax revenue by about $100 billion a year, President Biden has kept the limit on the SALT deduction because it will increase federal tax revenue to pay for his ambitious spending agenda. His keeping the SALT deduction exposes President Biden’s real agenda and ethics. President Biden does not care about the morality of taxing income twice, he likes the idea of more tax revenue at the cost of ethics and transferring more power and more money to the federal government.

Image Source: Flickr | LBJ Library
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