Thursday, January 25, 2018

Blue State Taxpayers and Regressivity

by Neil H. Buchanan

One of the most openly partisan provisions in the tax bill that Donald Trump signed last month was the limitation on the deduction for state and local taxes (SALT).  How can that be partisan?  Because so-called blue states collect more in taxes than red states do, allowing the blue states to provide more services to their citizens while red states starve their public sectors.  Limiting that deduction thus increases taxes on blue state taxpayers.

The ability to deduct SALT payments when computing federal taxes is, in fact, one of the only ways that the federal government helps blue states.  Red states are generally net recipients of federal money while blue states are net payers, and the difference can be large.  Focusing only on the SALT deduction deliberately obscures that larger reality.

In part one of this two-part series of columns, I noted Michael Dorf's argument that the effort by Trump and the Republicans in Congress to specifically target taxpayers based on their voting patterns is a violation of the Constitution (which nonetheless probably cannot be vindicated in court), and I also described how the governments of blue states have been trying to come up with ways around the new law, setting up "charities" to which people could send their state tax payments.  Because Republicans did not limit the charitable deduction, this would neatly sidestep the new limit on SALT deductions.

That strategy might not ultimately work, but on the other hand it might.  But other than serving to frustrate the partisan hit job that Republicans pulled off with their tax law, would it actually be a good idea for the Democrats to do so?  More provocatively, as I asked at the end of part one: "Should liberals actually be trying to reduce the tax bills of arguably comfortable people in the name of foiling conservatives' attack on state governments?"  Spoiler alert: I said that the answer is yes.

To be clear, it would be much more direct and effective to repeal the bill and then to replace it with something much more progressive.  Doing that, however, will not happen unless and until Democrats win some elections in 2018 and 2020.  In the meantime, they should try to make progress where they can make progress.

Before getting into the political philosophy of taxes, it is worth getting a sense of what is at stake.  Consider a person making about $250,000 per year who lives in a house that she owns near a big city in a typical blue state.  There is no question that such a person is comparatively comfortable, with an income higher than 85 or 90 percent of the citizens in her metropolitan area.  On the other hand, she is not part of the true economic elite that has been doing spectacularly well since the beginning of the Reagan era.

Such a person could easily be paying as much as $10,000 per year in property taxes, and her state and local income taxes might add up to something like $13,000 per year.  Under pre-2018 law, she could thus deduct $23,000 in state and local taxes when computing her federal taxable income.  Limiting her to a maximum of $10,000 in SALT deductions is thus rather significant.

This taxpayer is likely to be in the 32% tax bracket under the new law, which means that she loses 32 percent of $13,000, or $4,160, due to the limitation on SALT.  There are, of course, many other moving parts under the new law, but this at least gives us a sense of what is at stake for an upper-middle-class person who was targeted by the Republicans.

Of course, the stakes rise as incomes rise, because wealthier taxpayers likely own more expensive houses and pay more in taxes to their states and municipalities and thus will lose even larger chunks of their previously deductible SALT payments.  And because they are in higher tax brackets, each dollar not deducted hits their bottom line harder.

Before getting into a debate that has broken out among liberals about how best to respond to the Republicans' political targeting, I can first dispense with a talking point from Republican congressman and House Majority Leader Kevin McCarthy.  (McCarthy, you might recall, is the would-have-been Speaker of the House who accidentally dropped a truth bomb about how the Republicans had doggedly pursued the Benghazi non-scandal specifically to hurt Hillary Clinton's poll numbers.)

When the tax bill was still being debated, McCarthy was taking heat in his home state of California for being in favor of a bill that would increase taxes on that bluest of blue states.  His response was that California's upper-middle- and upper-class taxpayers should be happy about the bill, because it reduced their tax rates.  As it happens, that would not even be true for all taxpayers (such as my hypothetical 250k-per-year person, who would have seen her tax rate increase under the new law), but it is true that the top bracket was decreased from 39.6% to 37%, starting at $500,000 of taxable income for single filers.

So McCarthy's argument was that relatively wealthy Californians should be happy because their overall tax liability is likely to decline -- this is, after all,  a stroke-the-rich tax bill and thus lavished its cuts on the highest-income taxpayers and corporations throughout the country -- so they should simply shut up about the SALT limitation.

The problem with that argument, of course, is that the higher-income taxpayers in red states are also receiving the benefits of those lower rates, but they did not lose anything due to the SALT limitation.  Even if rich Californians' taxes are going down, they are not going down as much as rich Texans' taxes.  And again, because richer Californians are more likely to vote Democratic than richer Texans are, that suited McCarthy and the Republicans just fine.

All of that, however, is a matter of horizontal inequity, where people with similar incomes and living standards are being treated differently by Republicans based on whether their state governments are well funded -- that is, whether they live in a blue or red state.  The more interesting question is whether fixing that problem (through the taxes-as-charitable-deductions strategy or any other) is a good idea as a matter of vertical equity.

Vertical equity, more commonly known as progressivity, or taxing based on the ability-to-pay principle, is the primary long-term target of Republicans.  Their arguments for so-called flat taxes and many of their other regressive gambits are typically variations on the claim that everyone should pay the same tax rate, because a progressive tax system is unfair and "punishes" rich peoples' success.  That is nonsense, but it is their go-to argument.

One high-profile progressive tax-oriented think tank recently issued an analysis saying that blue states should not try to undo the Republicans' SALT limitation, because the people who are harmed by this limitation are higher-income taxpayers.  To undo the SALT limitation, therefore, would harm vertical equity by making richer people better off without helping poorer people (who either do not reach the $10,000 limit or, more likely, do not itemize in the first place).

This argument is true on its own terms but ignores the important broader aspects of the story, and it provides a useful lesson in how thinking too narrowly about taxes can cause even smart people of good will to make bad policy pronouncements.

If they do not find a way around the SALT limitation, what will state governments do?  One possibility is simply to tell their higher-income taxpayers that there is nothing to be done.  Another possibility, however, is that state governments will start to feel some pressure to reduce their own taxes to partly offset the higher federal taxes.

Indeed, this is exactly what Republicans are hoping will happen.  They want to put the screws to the states and cities that run minimally decent safety nets, fund good public schools and universities, and so on.  To the extent that this happens, blue states will find themselves undermining public services in the name of softening the effects for higher-income taxpayers of the SALT limitation.

In other words, it is too limiting to focus only on the fact that a blue state workaround would directly help that state's upper-middle- and upper-class taxpayers.  Just as it was not true that the pre-2018 federal fiscal system subsidized blue states in the aggregate (because of how the money is spent and not just how revenues are collected), one needs to look at how states will respond to an unfavorable change in the law.

To put the argument in more familiar terms, people such as the hypothetical blue-state taxpayer described above could reasonably be asked to pay four thousand extra dollars per year if the money were to be spent on, say, making sure that drinking water does not cause brain damage in poor children; but it is unreasonable to ask that person to pay more in taxes to subsidize significantly richer people's tax cuts (personal and corporate).

That think-tank report, then, is correct in saying that allowing people to use an unlimited SALT deduction is a regressive policy in the sense that it directly benefits only higher-income taxpayers.  Even so, the direct impact is never the end of the analysis.

Fighting back against the Republicans' unconstitutional targeting of people who tend to vote for Democrats is important on its own terms.  That such a fight also will help blue states continue to do what blue states do well makes it an even more important battle.


John Barron said...

It'll never happen--Dems don't HAVE balls!--but imagine them saying that the price for the eight votes the Rs need to prevent default is a total repeal of the Bribery Yields Fantastic Returns Act of 2017.

So, are you REALLY going to shut the government down to ensure that multinational corporations can raid our Treasury, Senator McConnell???

Call it the Reverse-DACA.

Joe said...

We got to put the screws on them, guys.

I'm wary of this "unconstitutional" talk -- there might be differences between the states here that can sensibly result in splits with a partisan edge. Winners also will burden the losers at times -- election has consequences. The use of such logic can come back and bite good policy. This holds even if the policy is horrible on the merits. I see it as basically a political question [which doesn't on its own make it "constitutional" -- see impeachable offenses] though the argument put forth is convincing on some level.

Greg said...

I'm not sure I buy this argument.

Suppose, for instance, that rather than the federal government capping the amount that could be deducted, the states instead added another high-income tax bracket that increased taxes by another 3%. Would we then argue that raising taxes is a bad idea because it will cause the state to lower taxes? If there were some charity trick to avoid having to pay the extra state tax, the above argument further says that doing so is a good idea because it will prevent the state from lowering taxes to pay for the increased taxes. Still doesn't seem to make sense to me.

If we treat the state and the federal government collectively, that's exactly what's happened. In this case, it's the federal government that has chosen to raise taxes for high-income taxpayers, but why is state taxation fundamentally preferable to federal taxation?