Why the debate over SALT deductions matters

Amid the wrangling over the Build Back Better (BBB) legislation, the version passed by the House of Representatives to increase the $10,000 cap on state and local taxes (SALT) to $80,000 has been lost in the shuffle. With Sen. Joe Manchin (D-W.Va.) threatening to vote no unless program costs are reined in, many observers believe a significant increase in SALT deductions is effectively dead on arrival. At the same time, some House Democrats from the tristate region (N.Y., N.J., Conn.) are threatening to vote no if the deductions are not increased. 

Whatever its fate, people should understand that the issue is more complex than a tax break for wealthy individuals. First, the debate over SALT deductions raises fundamental questions about the taxation policies of high- and low-tax states. Second, it also involves a judgment about whether the combined federal-state-local tax for the states most affected by the deduction is unduly burdensome. 

Many observers view SALT deductions as a “red state versus blue state” issue. In the negotiations over the Tax Cut and Jobs Act enacted in 2017, Republicans saw the cap on deductions as a way both to save costs and also to penalize states such as California, New York and New Jersey for enacting high taxes and then seeking offsets from the federal government. (Note: Previously there was no cap on SALT deductions, and the Tax Foundation estimates that 91 percent of the benefit was claimed by those earning more than $100,000 in six states.) 

In the current debate about whether to increase the deduction, Sen. Chuck Grassley (R-Iowa) stated, “This is something that will bring down their Build Back Better, because it was really a blue-state billionaire bailout.” Ironically, this makes it seem like it is Republicans who are opposed to lowering the taxes of the wealthiest while the Democrats appear to being favoring them. 

So, what explains this anomaly?

My take is that it stems from sizable payments imbalances between individual states and the federal government. Democrats from the most populous states favor increased SALT deductions mainly because their states are net payers to the federal government, whereas most Republican-controlled states receive more in transfers than they pay in federal taxes. 

A report by Laura Schultz of the Rockefeller Institute of Government sheds light on the size of payments imbalances for each state. It found that New York was the single largest net contributor, with net payments to the federal government totaling $143 billion over five years ending in 2018. New Jersey and Massachusetts were the next highest on the list, with California and Connecticut rounding out the top five. 

By comparison, 40 states were net recipients of funds from the federal government. The predilection of many red states to enact tax cuts (which typically benefit high-income households) and to require balanced budgets has created funding crises in their education systems. Kentucky, Oklahoma and West Virginia, for example, have faced teacher strikes that have forced legislatures to confront how policies have deprived their educational systems. If these states seek to attract skilled workers, they will ultimately need to invest in infrastructure, schools and health care.

Accordingly, Democrats from large states argue that SALT deductions help to avoid “a race to the bottom” with red states. The argument is that the transfers these states receive from the federal government enable them to pursue low-tax policies.

Another concern of Democrats is that the cap on SALT deductions could encourage businesses and the rich to migrate to lower-tax states. But sociologist Cristobal Young’s book “The Myth of Millionaire Tax Flight” suggests otherwise. After examining 13 years of tax returns for millionaires, Young found that just 0.3 percent of them move to lower tax jurisdictions in a given year. The essence of Young’s argument is that most millionaires are tied to where they currently reside, especially if they are married and have children, and that taxes are a marginal consideration in where to live.  

Still, a big unknown is whether the COVID-19 pandemic may have altered the equation. With many people now working remotely, some are opting to move from large urban centers to warmer climates and areas where the cost of living (including taxes) is lower. According to the Census Bureau, the net outflow of residents from California and New York in the 12 months ending June 30, 2021, totaled 720,000, while Florida and Texas experienced net inflows of nearly 400,000. At this juncture, it is too early to know how prevalent this will be once the pandemic is brought under control. 

Finally, another consideration is whether the combined federal, state and local tax burden is reasonable for the states most affected by the SALT deduction. According to the Tax Foundation, the states with the highest state and local taxes are in the tristate area in the range of 12-13 percent, followed by Illinois, California and Wisconsin at 11 percent. This means the wealthiest households in these areas have a combined marginal tax burden of 50 percent or more when federal taxes are included.

These calculations, moreover, do not take account for differences in the cost-of-living by states. According to Richard Barrington of MoneyRates, Hawaii and California have the two highest cost-of-living expenses nationally, with New York being in the top 10. 

Weighing these considerations, my take is that taxpayers in the tristate region and California bear an undue tax burden relative to the rest of the nation. While a SALT cap deduction of $80,000 may not be in the cards, a compromise proposed by Sens. Bernie Sanders (I-Vt.) and Robert Menendez (D-N.J.) that would establish a threshold income for the deduction is a reasonable approach to the problem.

Finally, Democrats in suburban swing districts have a stake in the outcome. According to an article in Bloomberg commentary, many voters in affluent suburbs across the country abandoned the Republican Party in the 2018 congressional elections as a protest against the $10,000 SALT cap the GOP set. This time, they could tilt back to Republican candidates if Democrats fail to lift the cap.

Nicholas Sargen, Ph.D., is an economic consultant affiliated with Fort Washington Investment Advisors in Cincinnati and the University of Virginia’s Darden School of Business. He has authored three books including “Investing in the Trump Era.”