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4 States Just Sued Over the Federal Tax Law. Here's Why They Might Lose.

Connecticut, Maryland, New York and New Jersey argue that new GOP tax policies violate states' rights and unduly punish their populations.

IRS headquarters
The Internal Revenue Service building in Washington, D.C.
Four blue states sued the federal government on Tuesday over tax changes that the GOP-controlled Congress adopted in December.

Connecticut, Maryland, New Jersey and New York filed a joint lawsuit alleging that the federal government's new $10,000 cap on deductions for state and local taxes is unjust because it violates the U.S. Constitution’s Equal Protection Clause and the 10th Amendment, which protects states’ rights. 

Calling the deduction cap an "unconstitutional assault" on state governance, the lawsuit accuses the federal government of meddling in state taxation and fiscal policies by making it more difficult for them, politically, to raise revenue if needed.

"The new cap disregards Congress’ hitherto unbroken respect for the states’ distinct and inviolable role in our federalist scheme," the lawsuit says. "And, as many members of Congress transparently admitted, it deliberately seeks to compel certain states to reduce their public spending."

The suit notes that President Trump has said the new cap was intended to force states like New York to change their policies or they were “not going to benefit” from the 2017 Tax Act. It also cites Treasury Secretary Steven Mnuchin’s statement this year that the cap was intended to “send a message” to high-tax states.

But that argument -- that the law is unconstitutional because it affects different states in unequal ways -- is a weak one, Jared Walczak of the conservative-leaning Tax Foundation told Governing in January.

Practically everything Washington does impacts states unevenly, he said. For example, Florida and other states with higher retiree populations get more federal Medicare and Social Security dollars than other places. Meanwhile, the alternative minimum tax, which is designed to keep wealthy taxpayers from using loopholes to avoid paying taxes, targets a lot of residents in places like California, Connecticut and New York.

“And no one has suggested that the alternative minimum tax is unconstitutional,” Walczak said. “[The lawsuit uses] a very novel argument and not one that is usually credited to the Equal Protection Clause.”

Capping the state and local tax deduction to $10,000 was one of the ways Congress tried to offset the cost of lowering federal income tax rates. The cap, combined with new limits on the mortgage interest deduction, is expected to generate an additional $668 billion for the federal government over the next 10 years, according to the Joint Committee on Taxation. Although Republican and Democratic lawmakers in states with higher taxes fought unsuccessfully against the cap, the policy is generally seen as disproportionately impacting liberal-leaning states.

“It has nothing to do with sound policy,” New Jersey Gov. Phil Murphy said during a press conference earlier this year announcing the impending lawsuit. “It is clear: It is punishment.”

Congress has nipped and tucked the state and local tax deduction before.

When the federal income tax was first instated in 1913, all state and local taxes not directly tied to a benefit -- such as the sales tax -- were deductible against federal taxable income. Then in 1964, Congress limited deductions to property, income, sales and motor fuel taxes. Fourteen years later, motor fuel taxes were eliminated from qualifying. And in 1986’s tax reform, sales taxes were eliminated from deductibility -- a move that disproportionately impacted taxpayers in states with no income tax. In 2005, Congress reinstated the sales tax deduction but only allowed taxpayers to deduct either income taxes or sales taxes (not both).

“So, over the years, Congress has apparently felt like they could narrow the deductibility,” says Thomas Gais, director of the nonpartisan Rockefeller Institute of Government, told Governing in January. “I’d assume they imagine they can get rid of the whole thing if they wanted to.”

Tuesday's lawsuit argues that states only ratified the 16th Amendment -- which instituted the federal income tax -- on the understanding that the federal government’s income tax power "was required to accommodate the sovereign tax power of the states when it imposed a federal income tax."

Where the states might have a more credible argument, Gais said, is leveraging the 10th Amendment to prove that the new federal tax law destroyed a century-old tax structure between the federal government and the states.

“The feds and the states share responsibility,” said Gais. “[States] need to be able to raise money, especially when there are health care proposals that would limit Medicaid expenditures and probably other budget cuts coming at the federal level.”

But Walczak and Gais both said they doubt that amounts to a 10th Amendment violation of a state’s right to govern itself.

In fact, Walczak says, high-tax states’ uproar over capping the deduction is in conflict with the argument often heard within those states that tax rates play a minor role in businesses’ and individuals' location decisions.

“New Yorkers may favor a larger government, and if they want to pay for it, that’s a New York decision,” Walczak says. “So maybe what we’re hearing is that New Yorkers aren’t as willing to subsidize that as leaders have been saying.”

Liz Farmer, a former Governing staff writer covering fiscal policy, helps lead the Pew Charitable Trusts’ state fiscal health project’s Fiscal 50 online resource.
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