Baker Institute expert explores tussle over tax reform and deduction limits

The Tax Cuts and Jobs Act of 2017 placed a $10,000 limit on the amount of state and local taxes people may deduct on their federal income tax returns. One year after the law’s passage, this so-called SALT deduction limit remains one of its most contested provisions, according to an expert in the Center for Public Finance at Rice University’s Baker Institute for Public Policy.

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Joyce Beebe, a fellow in public finance, examined the pros and cons of the limit and state-level efforts to circumvent the caps in a new report, “Fiscal Federalism and the State and Local Tax Deduction Limit.”

Prior to the tax reform, there was no cap on the amount taxpayers could claim for the deduction. Several states have since proposed or passed legislation to circumvent the limit. In response, the IRS issued a warning against state charitable contribution workarounds in May, followed in August by proposed U.S. Department of Treasury regulations intended to block those state actions.

Four states (New York, Connecticut, Maryland and New Jersey) filed a lawsuit against the federal government, claiming the cap unfairly targeted them and represented federal interference with states’ constitutionally protected rights. In November, the federal government sought to dismiss the case, arguing that the states do not have legal standing to file the lawsuit.

“Beyond the pointed statements between the federal and state government officials, these arguments bring up an important issue: What are the existing fiscal interactions between the federal and state governments, and how would the SALT deduction cap change these dynamics?” Beebe wrote.

Her report reviews the connections between the governments and summarizes the viewpoints for and against a SALT deduction limit. It also discusses recent state actions to mitigate the effects of the cap, as well as federal government reactions and individual-level workarounds.

“Fiscal federalism, which describes the financial relations between different levels of government based on their respective responsibilities, is a unique and indispensable feature of a federal government system,” Beebe wrote.

The federal government provides substantial financial assistance to state and local governments. Beebe’s report focuses on two of the largest federal support mechanisms — federal grants and the SALT deduction.

“Although removing the SALT deduction cap would cost the federal government more than $600 billion over the next decade, newly elected Democrats from high-tax states have begun discussions on either increasing or removing the cap,” Beebe wrote. “The partisan nature of the tax reform and the high level of fiscal deficits mean the limited SALT deductibility would have profound revenue implications, and the adversarial relationship between state and federal governments would intensify. Although the SALT deduction cap has been interpreted as a political move to harm blue states, or a maneuver simply to finance the TCJA, there is no doubt the federal government provides substantial financial assistance to state and local governments.”

Because the SALT deduction is administrated through federal tax policy, the key economic issue centers on the magnitude of the spillover effects of state and local government spending, Beebe said.

“Some of the workarounds may prevail on legal grounds, but whether they make good state tax policies is a separate matter,” she wrote. “Key state-level issues on both revenue and expenditures need to be addressed. The growing spending on entitlements and the looming budget shortfalls require not only efficient administration but also a reconsideration of spending priorities.”