The Build Back Better bill put forth by the Biden Administration addresses a variety of domestic social policies from climate and immigration to education, healthcare and tax law. As proponents of the bill seek support and await a vote in the U.S. Senate, there is still time to consider raising the cap on state and local tax deductions with a view to balancing high- and low-tax states.
Restructuring the Deduction for State and Local Taxes
In 2017, Republicans, who then controlled Congress, placed a $10,000 cap on the deduction for state and local taxes (SALT). This move was widely perceived as politically motivated, since states with high income tax rates tend to be run by Democrats. By limiting the amount of state and local taxes that could be deducted, Republicans increased the federal tax payable by those who pay a lot of state and local taxes; those taxpayers tend to be higher-income Democrats in high-tax states.
Democrats, who now control Congress by a thin margin, have been struggling to restore the SALT deduction, but have run into problems: the proposed fixes cost a lot of revenue and tend to favor higher-income taxpayers. Taxpayers with lower amounts of income are not affected because they don’t pay enough in taxes to reach the SALT cap. Removing the $10,000 cap altogether tends to benefit higher-income taxpayers, since it would restore their large deductions for SALT paid.
To find a way to restructure the deduction in a manner that restores the pre-2017 balance between high- and low-tax states, we should go back to first principles. There is general acceptance of the idea that one’s income tax should go up progressively with the amount of one’s income, but it gets complicated where more than one jurisdiction taxes that income.
If that jurisdiction is a foreign country, the typical approach is to give a credit for the foreign tax paid. (A credit offers even more relief than a deduction, since it involves a 100% offset of the foreign tax paid.)
If the jurisdiction is a lower level of government, like a state, one approach is to provide a deduction for the state income tax, on the theory that this tax reduces the amount of disposable income available to be taxed at a federal level.
For example, suppose there are three individuals: A, B, C.
Individual A earns $1,000,000, lives in a high-tax state, and pays state income tax of $100,000.
Individual B earns $1,000,000, lives in a no-tax state and pays no state income tax.
Individual C earns $900,000 and lives in a no-tax state.
Allowing Individual A to deduct the state tax of $100,000 would place A in the same position as Individual C, who earns $900,000 and pays zero state income tax in their no-tax state.
Both A and C have $900,000 left in disposable income after paying any state income tax. This is the conceptual justification for the state income tax deduction.
It seems reasonable to find that B has greater taxable capacity than A.
A better approach for SALT would be to use a floor based on adjusted gross income rather than a fixed dollar amount.
Even if there is a theoretical case for allowing everyone to deduct the SALT they pay, practical considerations might limit the deduction. To avoid everyone having to keep track of all their deductions, we have a system whereby deductions are allowed only if they exceed the standard deduction. After 2017, this system has been thrown off balance because the standard deduction amount has been substantially increased, with the result that very few taxpayers itemize. The standard deduction is a fixed dollar amount, now set at approximately $13,000 per person. A better approach for SALT would be to use a floor based on adjusted gross income (AGI) rather than a fixed dollar amount. With a floor, those taxpayers whose SALT payments are high compared with their income receive relief for the excess.
For example, if the floor is set at 5% of AGI, the amount of the floor would be $5,000 for someone with income of $100,000. Suppose that such a person pays $7,000 in SALT. Then they would be able to deduct the difference ($2,000). I would allow this deduction regardless of the standard deduction, i.e.,regardless of whether other deductions are itemized.
Setting the Floor
A floor has four main justifications.
First, it results in providing relief only for those taxpayers who experience above-average amounts of state tax paid. This is similar to other floors for deductions. For example, for medical expenses, the floor is 7.5% of AGI. This means that only unusually high expenses are deductible. Average amounts of expense do not give rise to a concern for tax equity.
Second, setting a fairly high floor greatly reduces the revenue cost of eliminating the SALT cap. This makes it easier to pay for the reconciliation bill as a whole, and addresses concerns about the federal budget deficit.
Third, the floor is progressive, because the non-deductible amount increases with income. With a 5% floor, a taxpayer with income of $100,000 cannot deduct the first $5,000 of SALT; and a taxpayer with income of $200,000 cannot deduct the first $10,000.
The floor can be made even more progressive—to avoid concerns that a benefit is being provided to upper-income taxpayers—by using two or more floors that increase with income. The proposal below uses a 7.5% floor for AGI in excess of $250,000, and 9% for AGI of over $400,000.
Finally, with a floor, all SALT is deductible at the margin. This means that if a state increases the income tax for higher-income taxpayers, all of the additional tax will usually be deductible. This makes it easier as a political and policy matter for states to increase taxes on the wealthy.
To further reduce revenue loss and align with current law, there could be a rule that only taxpayers who deduct more than the current $10,000 cap are subject to the floor.
To further reduce revenue loss and coordinate with current law, there could be a rule that only if you deduct more than the current $10,000 cap would you become subject to the floor (but also you should then be allowed the deduction even if you otherwise do not itemize). This means that those who itemize deductions would be subject to the $10,000 cap as under current law, and then there would be a separate deduction—available to both itemizers and non-itemizers, but subject to a 5% floor, as well as a higher floor or floors.
Here is one possible structure for the rule: A special (above-the-line) deduction for SALT would be allowed, regardless of whether the taxpayer itemizes deductions or not. The amount of the deduction would be the amount of state and local taxes paid, reduced by the sum of —
(a) $10,000, and
(b) 5% of the taxpayer’s AGI (increasing to 7.5% in respect of the portion of AGI in excess of $250,000; 9% in respect of the portion of AGI in excess of $400,000).
Under this rule, someone paying $10,000 or less in SALT will not be able to benefit from this special deduction: they will be able to deduct their SALT paid only if they itemize. Those seeking the benefit of this special deduction would first have to subtract $10,000, regardless of whether they deduct this amount as an itemized deduction or not, and in addition would have to subtract 5% of AGI (7.5% for AGI in excess of $250,000, and 9% for AGI in excess of $400,000). There is no limit on the deduction, but because the floor is progressive, the amount deductible by the wealthy is reduced.
Without access to the revenue estimating models that are available to congressional and Treasury Department staff, I cannot be sure about the revenue impacts of different levels of floors. However, the revenue can be readily estimated, and the levels of floors suggested here could be altered so as to achieve the desired revenue effect. By definition, there will be some revenue loss from this proposal, as compared with current law, since it involves an additional deduction to what is allowed currently, but the floors can be adjusted to keep this to a minimum if desired.
It should also be noted that since other parts of the Build Back Better bill raise tax rates on wealthy taxpayers, the bill should involve an overall increase in the tax paid by wealthier taxpayers, even if it includes a SALT liberalization as proposed here.
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Victor Thuronyi
