California and the Case for Restoring the SALT Deduction

On Wednesday, I highlighted how California Democrats have enacted incredibly progressive state tax policies and a strong economy, while not only building majority support overall but actually getting majority support from whites in the state – something Dems in very few states are pulling off.

Today, I want to highlight what an outlier California is in the progressivity of its tax code – and how wide-ranging the states are in how much the wealthy get taxed.   There is a lot of focus in D.C. on moving the top marginal tax rate up on the very wealthy by a couple of percentage points, while far less on the fact that the marginal tax on the wealthy varies by up to ten percentage points depending on what state they live on.  

And with this in mind, I’m going to (tentatively) come out for restoring the State And Local Tax (SALT) deduction, since there are reasonable arguments – not definitive but compelling – that eliminating SALT may encourage rich people to move to lower-tax states and, even more compelling arguments that it’s encouraging states to lower taxes on the wealthy out of fear that they will move out.  This in turn means that SALT cap isn’t raising overall taxes on the wealthy as much as billed and is helping to starve local governments of needed long-term revenue.

How Awesome is California’s Tax System?

But let’s start with how awesome California is in taxing the wealthy. It’s not just that they have the highest taxes on their richest residents, a full 12.4% tax rate (as of 2018 when these numbers were calculated), but that they manage to keep their overall taxes on their middle income and poorest residents lower than many states like Texas which tax their wealthy so lightly. 

See this graphic for a selection of states, where the tax rate on the wealthy varies from California’s 12.4% down to as low as 1.9% in Nevada. But look at the column in blue on the right, showing the difference between what the very rich are taxed and what middle-income residents are taxed in a state.  What pops out is that California is literally the ONLY state where the wealthy pay a significantly higher tax rate than most people in the state. In all but four states, the rich pay LESS than average-income residents, and in most, they pay far less. (See full data at the Institute on Taxation and Economic Policy’s WHO PAYS? page)

The Case for the SALT Deduction

Given this reality, there’s good reason why forty-one Democrats representing California, including progressive leaders like Katie Porter, signed a joint letter urging restoration of the SALT deduction.  They argue that eliminating the SALT deduction was designed to punish states that tax the wealthy and “specifically targeted states and localities that have chosen to provide strong taxpayer support for critical government services such as education, health care, transit, and social services.”

Now, it is very accurate to criticize the SALT deduction on the grounds that deducting state and local taxes benefits the wealthy- as Brookings argues in this piece- so restoring the full SALT deduction (if done in isolation) would cut the taxes of the very wealthy by as much as $70 billion per year.  As the Brookings researchers argue, there are far better ways to spend that kind of money.

But here’s the rub.  Those numbers are only accurate if the wealthy are actually paying state taxes that would then be deducted.  If the wealthy are encouraged to move to lower-tax states or, even more likely, states respond to the SALT deduction cap by reducing taxes on the wealthy in their states, then eliminating the SALT deduction doesn’t gain as much revenue for the feds.  And the lower revenue in states cutting tax on the wealthy like the personal income tax would lead to state and local services getting further gutted.

While there is relatively little evidence of large numbers of wealthy people moving based on tax rates – see these studies – the impact of Covid lockdowns may have led to more recent outmigration, where we will need further studies to see their tax impact.  

But what is true is that multiple states have taken action to reduce taxes on the wealthy, citing SALT as motivation in many cases.  Per the Tax Foundation, in 2021 alone, 10 states have reduced individual income tax rates, including reducing the top marginal rate in 9 of those states.  As the Tax Foundation details, “there is every reason to believe that more states will follow, if not this year, then undoubtedly in 2022.” (See table below)

As the Arizona Center for Economic Progress details, the plan passed in that state was massively regressive, delivering 93% of its cuts to the richest 20% of residents. The top 1% alone will get 55.48% of those tax cuts with an average tax savings of $30K per household.

With more states discussing further tax cuts, particularly for those in top tax brackets, take any projections on the revenue from eliminating the SALT deduction with some skepticism, since gains at the federal level may be significantly offset with losses in revenue at the state level.  It’s not just the red and purple states cutting taxes this year; politicians like Andrew Cuomo in blue states like New York cited to SALT as an argument to limit revenue increases in the budget passed this year as well.

The Politics of SALT

And there is no getting around the fact that repealing the SALT deduction was disproportionately a tax increase for residents of states, mostly Democratic ones, which actually try to create tax fairness, while rewarding residents of states like Florida and Texas who vote for politicians who fund public services disproportionately with regressive sales taxes and leave the rich largely untaxed.

Do we want a tax code that incentives voters to support right-wing state politicians?

This goes to the broader politics of taxes and budgets.  Any particular method of taxing the rich is not part of a zero-sum game since there are many approaches to ensuring they pay more.  If the SALT deduction is restored, that doesn’t mean overall taxes on the wealthy can’t increase significantly and possibly even MORE than if the SALT cap is kept in place.  There are likely moderate Democrats more willing to support a larger tax package raising taxes on the very rich, as long as they can deliver a tax cut on more of their merely well-off constituents getting whacked by the SALT cap.

And there is this particular galling aspect of the SALT cap: the wealthy donate money to super-elite universities or fund charter schools and get to deduct those donations from their federal taxes, but the state and local taxes they pay to fund public universities and local public schools are largely NOT deductible. 

Again, why would we subsidize the charities of the wealthy driving privatization, while refusing to subsidize the taxes paid to fund the public sector?  As long as the charitable deduction is in place, then the SALT deduction should be in place as well.

One other factor arguing against the SALT cap.  Multiple states have passed workarounds to the SALT deduction for high-income professionals who run their income through limited liability corporations or other “entities”, so it means the SALT deduction isn’t even applied evenly. 

This means partners at law firms for example – often organized as partnerships or S corporations – can largely gain the full deduction for state income taxes by paying them through their firm as a “business expense” before the profits are distributed to them, while other folks on regular salaries with comparable income end up paying far more in taxes because they get hit with the SALT cap.   All of this is creating new hellish complexity in the interaction of these pass-through entities and state and federal taxes—all adding to political resentment and an inequitable tax code.

I will leave this with what Ted Boettner at the progressive West Virginia Center on Budget and Policy wrote just before the SALT deduction cap was passed in 2017:

[T]he SALT deduction helps state and local governments fund public services with widely shared benefits, tax cuts for the wealthy do not. That’s because higher-income taxpayers are more willing to support state and local taxes because of the deduction. Repealing it would make it harder for West Virginia â€“ which is already facing serious budget strains – to raise adequate revenues over time for key services like education and transportation. It could also cause states to rely more on taxes and fees that fall harder on lower- and middle-income families.

Sure enough, the West Virginia governor in 2021 proposed largely eliminating the personal income tax in favor of far more regressive taxes.  Largely because the American Rescue Plan included language restricting the use of those funds for tax cuts (language inserted by Joe Manchin, credit where credit is due), the bill was just barely defeated this year, but will likely come back in the 2022 session.

Those favoring keeping the SALT deduction cap in place should pay more attention to the tax cut politics in critical states like Arizona and West Virginia, as well as its disproportionate impact on loyal blue states like California.  

There are plenty of ways to tax the rich while keeping the SALT deduction.  Let’s do those instead and reduce the incentive for states to cut taxes on the wealthy in reaction to federal policy.