The Biden Administration’s Build Back Bankrupt bill, as passed by the House of Representatives, proposes to cut income taxes for two-thirds of taxpayers in the upper one percent. Republicans are adamantly opposed. Yes, that seems like a strange role reversal, but the provision at the center of the controversy, the deduction for state and local taxes (the “SALT deduction”), eludes simple intuitions.
Until the 2017 tax act limited the deduction to $10,000, state and local income taxes were deductible in full on taxpayers’ federal income tax returns, subject only to overall limitations on total itemized deductions. The rationale for the deduction was fairness. To the extent that someone’s earnings are taxed, they aren’t really “his”; he is just an involuntary conduit from the source of the income to the taxing authority. It is arguably inequitable to treat those amounts in the same way as income over whose disposition taxpayers can exercise discretion. That is the case for allowing state taxes to be deducted when figuring federal income tax liability.
But fairness has more than one side. State tax income tax rates vary widely, from zero to over 13 percent. The federal income tax deduction effectively transfers tax burdens from high-tax to low-tax states. Equal treatment of citizens by the federal government, regardless of the tax policies of different states, is the rationale for capping the SALT deduction.
Equity is in the eye of the beholder and less easy to agree on than beauty. So long as one looks only at the federal level, there will never be consensus on which unfairness is worse. The debate can, however, be transcended by turning our gaze to the states. Indeed, one state has long had a fully equitable regime in place.
In Missouri, federal income taxes are deductible on state income tax returns. Hence, earnings passed through mandatorily to the federal government are taxed by the feds alone. At the same time, the tax liabilities of people who live outside Missouri are unaffected. Both notions of fairness are satisfied to a reasonable degree. Moreover, every state is free to adopt this solution without any action by the federal government. New Jersey, whose Congresscritters are leaders in advocating the SALT deduction (top N.J. marginal tax rate: 10%), could enact it tomorrow.
New Jersey won’t, nor will any of the other high-tax states. Their reticence illustrates the SALT deduction opponents’ contention: The proponent states are willing to be fair to upper-bracket taxpayers only if other states pay the price.
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