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.