SALT Deduction Cap Is Bad Policy and Should Be Allowed to Expire

The Tax Cuts and Jobs Act’s $10,000 state and local tax deduction cap was bad tax policy in 2017, remains bad tax policy now, and will be bad tax policy if retained when Congress revisits TCJA provisions that expire this year. And it reflects an underlying tax policy problem inherent in forbidding full deduction of all US income taxes paid at all levels of income taxation.

In tax policy circles, deductions, exclusions, exemptions, and credits are considered tax expenditures—essentially spending through the tax system to achieve non-tax political goals that generally can’t be accomplished politically through a direct subsidy.

Tax expenditures are inherently complex, inefficient, and expensive both fiscally and in terms of public trust. Better results are achieved by eliminating tax expenditures and raising just enough revenue to cover the direct and transparent expenses of running the country. Sound tax policy lies in broadening the base and lowering rates.

But we should be careful what we call a tax expenditure. At first blush, the SALT deduction appears to check all the boxes as a tax expenditure, and the SALT deduction cap appears to be unsound tax policy only because it doesn’t go far enough.

This conclusion lacks nuance. The SALT deduction cap cumulatively limits the federal deduction for state and local property taxes and either income taxes or, at the taxpayer’s election in lieu of income taxes, sales taxes.

Although deductions for property taxes and sales taxes are tax expenditures that should be eliminated purely from a sound tax policy perspective, there is a key differentiator for income taxes that leads me to conclude they should be fully deductible at all levels of the income tax system. Why is income tax the exception? It’s all about structure and economic substance.

The US individual income tax system is a web of federal, state, and local taxes that should be viewed as a single-tax ecosystem authorized within the confines of our constitutional government. At each level, the tax base is substantially the same.

If not for pressures of our political system, the income tax could be more efficiently administered and collected entirely at the federal level and then distributed to sub-jurisdictions (the states and localities)—similar to the approach taken by Maryland and discussed in the US Supreme Court’s decision in Comptroller of the Treasury v. Wynne.

Other than administrative costs, there is little difference to an individual making $400,000 in taxable income between being taxed at the federal level at a combined federal, state, and local rate of 35%—with directed federal distribution of funds to the states and localities—and being taxed at a 25% federal rate, an 8% state rate, and a 2% local rate. The individual is paying $140,000 in combined federal, state, and local income tax either way.

To keep things simple, assume that all tax payments are made in arrears, such that tax is paid on income in the year after its earned. Continuing the example above, the $400,000 earned in year 1 is subject to $140,000 tax in year 2.

In year 2, the individual earns another $400,000. If there is no deduction in year 3 for the tax paid in year 2, the tax due for year 2 and payable in year 3 is another $140,000.

That result doesn’t seem particularly problematic until you consider one important fact: The individual didn’t have a choice about paying that $140,000 in year 2. If they refused to do so, they could be charged with a crime and subject to forfeiture of property and imprisonment.

Accordingly, the individual only had the right to $260,000 of their earnings in year 2 and the remaining amount was ceded to the government. Of the amount due in year 3, $91,000 represents tax on year 2 earnings and $49,000 represents a hidden surtax.

This hidden surtax is what the SALT deduction, to the extent that it was for state and local income taxes, was meant to relieve. Splitting the combined 35% tax into a 25% federal rate and a 10% state and local cumulative rate—and then providing a full deduction at the federal level for state and local income tax paid—takes the example to the pre-TCJA status quo.

Total hidden surtax relief could only be obtained by allowing full deduction of all income tax paid at each level. For federal purposes, this would mean going back to the pre-TCJA deduction for state and local income taxes paid and layering on a deduction for federal income taxes paid.

Similarly, states and localities would have to provide the same deductions. What this would mean is that the individual’s year 2 taxable income reported in year 3 is $260,000 for federal, state, and local purposes at the applicable rates of 25%, 8%, and 2%, respectively, for a total tax due in year 3 of $91,000.

Why should we work to eliminate the hidden surtax? Because it is wrong to impose. We don’t tax priests who have taken a vow of poverty on their earnings because they have no contractual right to the income.

It makes no sense to treat income tax paid any differently merely because the earnings were paid over to the government under threat of imprisonment rather than to a church through a contracted-to act of faith. When Congress reconsiders the SALT deduction cap going forward, it should allow full deduction of state and local income taxes at a minimum.

Full deduction of federal income tax paid should also be allowed. And when the federal government eliminates its portion of the hidden surtax, the states and localities should follow suit.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Brian Kirkell is a principal with RSM’s Washington National Tax practice where he leads the team focused on state and local tax compliance and policy.

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