Now that the Republican tax reform bill is officially law, blue states are scrambling to figure out ways around one of the law's few actual tax increases: its new limit on deducting state and local taxes.
Under current law, taxpayers not claiming the standard deduction can deduct both their state and local property taxes, and either their state and local income taxes or their state and local sales taxes, whichever is higher. The Republican bill added a new $10,000 maximum for all state and local tax deductions, effectively raising taxes on wealthy people in those states and reducing a key federal subsidy that makes it easier for states to charge high taxes on rich residents.
A few possible options have emerged to evade the new limit, reduce taxes on blue state residents, and reduce future pressure for state tax cuts that the federal law could create. New York Gov. Andrew Cuomo, a Democrat, and the government of DC are urging residents to prepay their 2018 property taxes in 2017, so they can still be deducted. Another route would be for states to create dollar-for-dollar tax credits for all charitable contributions made to the state government. Charitable donations are still deductible under the GOP, so reclassifying state taxes as charity would enable residents to still deduct them at the federal level.
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But perhaps the most promising option, teased by a large group of tax law experts and vocally championed by prominent liberal economist Dean Baker, is for states to repeal their income taxes and replace them with employer-side payroll taxes. This might appear like a minor technical change. But it would not only totally offset the new limit on deducting state taxes — it would amount to a sizable tax cut for many middle-class families and would vastly simplify tax preparation by freeing people up from filing their own state taxes.
How the payroll tax fix works
You can levy payroll taxes in one of two ways: on the employer side or the employee side. In the US, we do both: Social Security and Medicare taxes amount to 7.65 percent on each. So for a hypothetical employee earning $100,000 a year, the employer first pays $7,650 to the government, and then deducts another $7,650 from the employee's paychecks and sends it to the government, leaving the employee's post-payroll tax take-home pay at $92,350.
Most economists agree that the distinction between having the employer and employee pay is basically arbitrary, and the employee ultimately pays the tax's full burden. Think of it this way: Assuming no other taxes and benefits, an employer paying $100,000 in wages has to effectively budget $107,650 to pay them, given the payroll taxes on the employer's side.
You could in theory eliminate the employer-side payroll tax, just tax the employee's wages, and get the same ultimate effect. Suppose instead of a 7.65 percent payroll tax on each side, there was a 14.2 percent tax just for employees. The employer would pay the $107,650 they already determined the employee's labor was worth, the employee would pay $15,286.30 in payroll taxes, and have $92,363.70 in take-home pay— almost exactly the same as under the old system. (You could set the tax rate at 14.2127264 percent if you want to get even closer, the $13.70 difference is just a rounding error.)
Or you could, equivalently, put everything on the employer's side. They budget $107,650 for the job, pay a 14.2 percent employer-side payroll tax, and set the employee's salary at $92,363.70, for the same ultimate effect.
This second option is what the state payroll tax fix to the Republican tax bill involves. States usually impose income rather than payroll taxes when raising general revenue, and levy them on the individual side. But they could tax wages on the employer side instead and accomplish the same thing.
And — this part is crucial — employer payroll taxes are still deductible under federal law. The business can just write them off their corporate income tax (or individual tax, if the business is a pass-through entity). Here are the 13 tax law experts mentioned above explaining why this works:
Taxes imposed on a business are still deductible. Therefore states can shift from non-deductible over-the-cap state income taxes to still-deductible employer-side payroll taxes. It is important to repeat that that states already impose a payroll tax for unemployment insurance purposes, and many localities impose an additional payroll tax as well—and employers currently can claim a deduction for their portion of these taxes.
Instantly, the federal change would be counteracted, at least as concerns state income taxes.
States could in theory only do this for income taxes in excess of the $10,000 cap. But they shouldn't, because employer-side payroll taxes are actually better policy for everyone, for two keys reasons.
First, payroll taxes are collected by businesses, not individuals, which vastly simplifies tax preparation for average individuals and families. I have paid vastly more in Social Security payroll taxes than state income taxes over the course of my career — but I've always had to manually file my state taxes, whereas Social Security taxes are collected for me automatically. Shifting state income taxes to payroll taxes would eliminate that effort for everybody, and make taxes significantly easier for average people.
California does offer an automated filing system for state income taxes, but its prefilled return option is rarely used and has been fiercely fought by TurboTax, H&R Block, and the tax preparation lobby. A payroll tax shift accomplishes the same thing, without making people opt in.
The second reason is it amounts to a tax cut for many middle-class people. Right now, you can only deduct state and local taxes if you itemize your tax return. Since the standard deduction is typically larger than itemized deductions for most lower and middle-income people, they don't really benefit from the SALT deduction at the present, and that will be even more true under the new tax bill, which nearly doubles the standard deduction.
But if states shift to payroll taxes, then businesses will be able to deduct all these employees' taxes for the first time, freeing up more of the money they've set aside for that employee to go to wages. It's possible, of course, that businesses would just pocket the cash — in which case it's no harm, no foul from the employee's perspective, and a windfall for businesses that choose to locate in these states. Then again, as the labor market tightens, it will get harder for employers to get away with that kind of thing, and there will be more pressure to use the money for wages.
The change might lead to higher take-home wages through another mechanism, too. Recall the example of the employee currently earning $100,000 a year. An employer-side payroll tax would effectively reduce their advertised salary from $100,000 to whatever their post-tax wage is, which could be many thousands of dollars lower.
Economically, that's all the same, and that person can expect to make the same amount of money. But it feels like a pay cut. Economists have found consistently that nominal (that is, not inflation-adjusted) wages are sticky. If you make $100,000 now, it's really hard for your employer to start paying you $90,000 in the future. If they think you're not worth $100,000, they're much likelier to just wait for inflation to slowly degrade your salary.
If that dynamic holds, then employees won't pay the ultimate cost of the new, higher payroll taxes. Employers will pay a big chunk. That amounts to a substantial windfall for the employees.
One wrinkle is that payroll taxes only affect, well, payroll. Other kinds of income like capital gains, interest, and dividends aren't hit by payroll taxes. To still tax that income and avoid a major tax cut for investors, states would need to pair the payroll tax shift with a new tax on capital income. There's plenty of precedent for that. Tennessee and New Hampshire don't have general income taxes, and only tax interest and dividend income. Under the payroll tax shift, a number of new states could join them, perhaps adding capital gains in the mix too.
The plan could run into some speed bumps, but they're likely surmountable
Baker and veteran California policy journalist David Dayen both report that policymakers in California are considering this kind of shift. In theory, there could be appetite in a number of liberal-dominated states, from New Jersey to Connecticut to Hawaii to New York (where Republicans control the State Senate, but only with the consent of a dissident faction of Democrats who might back this change). If Republican governors get on board out of a desire to look out for home state residents, Massachusetts and Maryland could be in as well.
But the plan isn't necessarily foolproof. The biggest obstacle would come if Republicans in Congress change the tax code to limit deductibility of employer-side payroll taxes, perhaps eliminating it at the state level. Then again, with tax reform signed into law Republicans have already used up their one opportunity for passing legislation with 51 Senate votes, and would need nine Democrats to support this change. It'd be a coup if they could get those defectors, but it's very unlikely.
The plan also jeopardizes state-level income tax deductions. States tend to allow fewer deductions and credits than the federal government does, but especially in states with state-level Earned Income Tax Credits, eliminating deductions and credits outright (perhaps except for a standard exemption, but even that could be hard to implement) would be a significant change, and potentially a tax hike on poor families. These states would need to think hard about how to implement the change in a way that ensures those families still get the benefits they receive under the current income tax regime.
Many state payroll taxes are also progressive, with lower and higher tax brackets just as under the federal tax code. If you work exclusively at one employer, that's fine, as they know your total income and can apply tax rates accordingly; this is how income tax withholding works, after all. But if you work at a bunch of different employers, and the brackets apply to your overall wages, reconciling that could be an administrative nightmare. This might be surmountable, but would require careful drafting of the law and regulation by tax collectors.
The plan could also lead to a significant backlash if employers decide to ignore their general tendency not to issue pay cuts and start slashing salaries to pay for their new tax burden. Employees shouldn't be alarmed if that happens, as it's a natural adjustment. But they probably will be alarmed. That could politically endanger the proposal. Then again, it could endanger employers more, and if they feel threatened and avoid pay cuts, that amounts to a big net boon for workers.
Overall, though, the change has significant upside. It makes taxes easier for workers, could result in a big net tax cut for the middle-class, and insulates states from the Republican tax bill. That should be enough to make Jerry Brown and Andrew Cuomo's ears perk up.
