October 21, 2020

Two Tax Reforms to Help the Middle Class and Main Street

In the HEROES pandemic stimulus bill they passed in May, House Democrats included a two-year waiver of the cap on federal income-tax deductions for state and local taxes that was imposed by the 2017 tax-cut law. That idea was dead on arrival with Senate Republicans, who see the SALT deduction as an unworthy subsidy that rewards “high-tax/high-spend” blue-state politicians, and it’s become a red plank in their political narrative.

Not every defense of the SALT cap is coming from the right, though. In a Brookings Institution blog post and a subsequent New York Times op-ed, Richard V. Reeves and Christopher Pulliam called removing the cap a massive handout for the rich and advocated eliminating the deduction altogether. Democrats have not been persuaded: Senate Minority Leader Chuck Schumer and other top Democrats say SALT reform will be a top priority if their party regains control of the upper house.

Reeves and Pulliam correctly explained how removing the SALT cap altogether would be regressive, tax-wise. Additional itemized deductions above the current $10,000 cap would primarily benefit upper-income taxpayers, not the working class. Only 14 percent of U.S. tax filers were subject to the SALT deduction limit pre-COVID-19, and high-tax New York and California were not really that different from the national average, at 17 percent. Even for New Jersey, notorious for its high property, sales and income taxes, only 27 percent of taxpayers are crimped by the cap. For everybody else, the ceiling was a non-issue.

For state and local officials, however, the SALT deduction is more than just Capitol Hill politics. To the extent that maybe 10 percent of state and local voters, the ones most impacted by the current SALT ceiling, will balk at tax increases for school bonds and public services, it becomes all that much harder to pass a funding referendum. These are very likely to be swing voters on tax proposals. A higher SALT-deduction cap could change that.

But are congressional Democrats, and especially those from high-tax states who represent affluent constituents, barking up the wrong, regressive tree here? Or is this a tax forest that isn’t clearly seen by viewing just the SALT tree? As it happens, there is a rogue tree nearby that also requires pruning to improve income-tax progressivity. But to see it clearly, one first needs to know some tax history.

In the professional field of public finance, the classic textbook for decades was Public Finance in Theory and Practice by Richard and Peggy Musgrave. They taught students of my generation that a federal deduction or credit for state and local taxes is needed to avoid double taxation of the same household income. Otherwise, the compounding of high federal, state and local tax rates could result in marginal taxation that ultimately becomes confiscatory. Back when they published the first edition of their book in 1973, the top federal tax rate was 70 percent, and their assertion was plausible when state and local taxes were piled on.

Then along came the federal Alternative Minimum Tax, designed to apply only to the millionaire class that had figured out how to dodge federal income taxes. Over time, as Congress scrounged for revenue, the AMT surtax was expanded to reach down to the upper middle class, and eventually the AMT eliminated the SALT deduction altogether when calculating its complex taxable income base. That threw millions of middle-class professionals straight into the AMT, which was hated by everybody trapped in that parallel tax universe.

In 2017, the Republican Party’s centerpiece tax reform law raised the threshold for the AMT to a much higher level, but to secure compensating revenues it put a cap on the SALT deduction. Most middle-class households were still better off overall because they were now freed from the hated AMT, and they also enjoyed a slightly lower tax rate on their earned income.

So the real question now is whether it makes sense to lift the SALT deduction ceiling somewhat, so that the cap is focused on One Percenters and not urban and suburban middle-class professionals. Politically, that is what the SALT debate actually comes down to, which makes it easier to see where most blue-state politicians are focusing. And it’s where the most decisive pocketbook votes may reside in hometown and statewide tax referenda.

Fortunately, there is a potential policy strategy for tax reformers. Going back to the forest surrounding the SALT tree, there is another tax break awarded in 2017 that also should be capped to pay for a modest but meaningful increase of the SALT deduction ceiling. That over-ripe tree is called the Qualified Business Income Deduction. QBID is essentially an insiders’ 2017 Trump tax loophole ostensibly for small businesses, self-employed gig workers and certain qualifying professionals. But its biggest beneficiaries are the ultra-rich who own private companies, as well as those involved in real-estate-development and oil-and-gas partnerships. Carping about “tax discrimination,” they complained they were being unfairly taxed at a higher rate than if they were able to enjoy the lower dividend tax rates and corporate tax rates that apply to public companies.

The problem with that is that their math is now invalid as a result of the 2017 tax cuts, as I documented in my 2019 book Enlightened Public Finance. Even without the QBID loophole, shareholders’ combined taxes on corporate profits, dividends and capital gains equaled or exceeded taxes on profits passed through from private companies. But the GOP tax-writers had found a constituency far more valuable and durable to them at the ballot box: the small-business community. Main Street business owners now get a windfall-bonus 20 percent deduction from their net business income on their federal taxes, even though there is actually no mathematical rationale. Guess which party they favor?

So, when Congress capped the SALT deduction, it turns out that two-thirds of the incremental revenue paid for the QBID deduction under the guise of AMT relief. They robbed Peter to pay windfalls to Paul.

In a progressive-tax forest, both deductions can be preserved for middle-income taxpayers but capped for the One Percenters. To raise the SALT limit, Congress could equitably put a similar cap on the QBID deduction. The precise math requires IRS tax data I have no access to, but my book’s ballpark math suggested that parallel $17,000 ceilings for each deduction could come close to revenue parity. Alternatively, federal taxpayers could deduct one or the other but not both, up to roughly $23,000 (which would spoil fewer local tax-hike referenda). Ultrawealthy private investors in businesses such as Koch Industries and the Trump-Kushner real-estate partnerships could no longer deduct millions on their business income, while most of America’s middle-class entrepreneurs and businesses would still enjoy meaningful tax relief.

What’s good for the goose should be good for the gander when it comes to capping deductions. So reformers need to learn the ins and outs of federal tax policy, if they want to play in the Capitol Hill hardball league where tax-savvy K Street lobbyists have a home-field advantage almost every time. And for state and local policy advocates roaming the halls of Congress, here’s your “pay-for” to make SALT reform revenue-neutral.

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