Tax bill: States look for ways around the new SALT deduction cap

The new tax bill President Trump signed into law last month hits high-tax, politically blue states like New York and California especially hard because of a new cap on state and local tax (SALT) deductions. But the states hit hardest by the change are already exploring ways around it.

The new law puts a $10,000 cap on SALT deductions. Previously, there was no cap on SALT deductions, which helped high-tax states raise revenue without taxpayers having parts of their income taxed twice, once at the state level and again at the federal level. The new cap means states might have to drop their tax rates or cut spending, lest they face the wrath of angry constituents with suddenly enormous tax bills.

New Jersey Governor-elect Phil Murphy, a Democrat, says his state will explore any and all options to make sure residents of New Jersey aren’t heavily impacted by the new legislation, and elected officials in other states have echoed those sentiments, including pols from New York, California, and Connecticut. Murphy even suggested challenging the law in court on constitutional grounds because of the SALT deduction cap.

The idea that appears to have the most traction, pioneered by economist Dean Baker, is shifting state income taxes to payroll taxes. Currently, payroll taxes are levied on both employers and employees; Social Security and Medicare are funded by a 7.65 percent payroll tax on both the employee and employer side.

The idea to skirt the SALT deduction cap would essentially move state income taxes to an employer-side payroll tax. The part of an employee’s salary that’s taken by employer-side payroll taxes doesn’t count as taxable income, so that tax could still be collected by states but would be exempt from an employee’s individual federal taxation. Also, companies are still allowed to deduct payroll taxes, so the damage to business would be limited.

Proponents say that, in effect, this move would preserve the SALT deduction, as states could lower their income tax rates by the equivalent of a raise in the employer-side payroll tax rate, which is still deductible for companies, while lowering an employee’s taxable income. This idea would hinge on companies not responding by slashing wages to offset their tax hike, but given the tax bill as a whole is a gigantic windfall for corporations, employers might overlook a small setback. Companies also rarely slash nominal wages; instead they may just let inflation erode the value of employee salaries.

Another more radical idea circulating among lawmakers is to change income taxes to a “charitable donation to the state.” These “donations” would result in a state tax credit of equal value, limiting the amount of income subject to federal taxation by the same amount. It would also effectively preserve the SALT deductions.

Both of these ideas would face their own set of obstacles and complications, political and practical, as the changes would domino through the tax code. In hopes of avoiding those pitfalls, lawmakers from states that have yet to legalize marijuana, like New York, have floated the idea of legalizing and taxing marijuana, then lowering state and local taxes to help offset the change.

With so many options being kicked around, the path forward for these states on SALT deductions is unclear. But lawmakers are clearly motivated to mitigate the damage to their constituents.

Curious if your city is impacted by the SALT deduction cap? Find your county with the interactive table below. In the upper left corner is “homes with property taxes higher than $10,000.” If that percentage is high, you might be affected.