A Sprinkle of Compromise to Appease Critics of the SALT Cap
Progressives and anti-taxers oppose blue-state proposals to remove the federal limit on state and local tax deductions. Reforms must address both tax competition and income confiscation.
Under the Trump-era tax cuts of 2017, a limit of $10,000 per tax return was imposed as a way to help fund cuts elsewhere, such as with the alternative minimum tax that often penalized the middle class more than the investor class. However, the SALT cap was just one piece of that tax cut bill. The 2017 law also reduced rates for the top bracket far more than the value of those taxpayers’ SALT deductions, and the Trump team also found a way to give a huge tax break to crony real estate investors and private partnerships with a 20 percent deduction on their income in what is called the QBID — the qualified business income deduction.
I’ve written previously that the QBID giveaway never made mathematical sense in the first place, since owners of private companies and partnerships already enjoy lower tax rates than the investors in public companies whose corporate income is taxed while their dividends and capital gains are also taxed at the individual level. So putting a comparable limit on the QBID at the same time the SALT limit is raised — let’s say to $20,000 per joint return — would provide tax relief to upper-middle-class taxpayers, entrepreneurs and investors without windfalls to One Percenters. For Democrats, it’s a fair trade, and provides some, though perhaps not all, of the revenue needed to raise the SALT ceiling.
But raising the SALT deduction cap to a level that appeases upper-middle-class constituents is only half of the issue raised by those seven blue-state governors in their appeal to President Biden. All of those states have high income tax brackets for the wealthy and now suffer from threatened and actual out-migration of their richest residents, those who shop tax venues with an eye toward relocating their primary residence to a low-tax or no-income-tax state.
This policy dilemma is what public finance experts call “tax competition,” a state-vs.-state race to the bottom to offer tax-haven benefits to the wealthy. The federal system needs to create a level playing field, one from which each state can make rational decisions without this federal tax policy gun to their heads, and then live with the consequences if they do indeed drive the rich to other venues by over-taxing them.
The pejorative complaint from wealthy taxpayers is that any movement to raise federal and state income tax brackets for millionaires is “confiscatory.” They point to the top federal marginal income tax rate of 37 percent (which is likely to revert to pre-Trumpian levels of 39.6 percent), plus the Medicare-funding investment-income surtax of 3.8 percent, plus their respective state and sometimes city income tax rates, which can be double digit — pushing the combined marginal rate above 50 percent for the top tiers. In New York City and all of California, for example, the state-local combination can add up to top marginal rates above 13 percent. Hawaii and New Jersey both peak above 10 percent, with Oregon and Washington, D.C., close behind at 9.9 percent. When you factor in the federal tax bite and around half of one’s earned income is taken away by tax collectors, a state’s proverbial taxpaying geese don’t just hiss or bite, they flee.
Just what level of taxation is truly confiscatory is debatable, but many fair-minded people would agree that working for less than half of one’s earnings after taxes is a logical reason to migrate to a lower-tax location if the combined rates are not capped. While accepting a responsibility to pay his fair share, billionaire Leon Cooperman has made televised arguments to draw the line at 50 percent. Mindful of that earnest but self-interested viewpoint, there are two important policy nuances that require closer review and deeper thinking:
● The SALT deduction is not limited to income taxes. It includes property and (sometimes) sales taxes, and nobody can argue that “confiscation of income” includes asset taxes on McMansions, especially in low-tax havens like southern Florida, where private wealth is shielded from creditors by homestead protection laws. If wealthy people choose to buy trophy homes, rare art and lavish yachts, that is their elective decision, not a reason to enjoy a federal income tax benefit.
● Most millionaires are not wage slaves working for salaries and bonuses, but rather are allowed to wallow in lower capital-gains income tax rates. This privilege applies notably to hedge-fund moguls, oil tycoons, real estate developers and the idle rich who inherited or built large portfolios that are now taxed at a 20 percent maximum federal rate. Again, one must ask whether a 20 percent marginal federal rate and a high-end 10-14 percent state and local income tax rate is actually “confiscatory.” Most salaried professionals would disagree, and would gag at providing tax relief to those One Percenters while they pay higher rates on the earned income reported on their W-2 forms.
To craft a fair compromise that addresses all these issues, a SALT deduction cap raised to $20,000 could be supplemented with an income tax “circuit-breaker” — a provision in the federal tax code to allow a direct income tax credit (not just a deduction) for only those top-bracket taxpayers whose combined federal, state and local income, and payroll taxes exceed 40 percent of their total adjusted gross income (not just their last, marginal dollars). Property and sales taxes must be excluded from this calculation, making it income tax specific. Income taxed at lower rates, like capital gains, would not qualify.
This circuit-breaker design eliminates confiscatory tax rates, while denying benefits to privileged investors and fund managers who already milk the federal tax code for lower rates. Looking ahead to the next budget bill, if Democrats in Washington eventually jack up the tax rates for rich investors and set a higher ceiling on the payroll tax, or if blue states set even higher rates for millionaires, then this meticulous tax offset would provide a reasonable safety valve to counter the recurring chants of “confiscation” by One Percenters and their congressional sycophants.
Robin Hood tax policies must have their limits. But millionaire blue-state investors should not forever have their cake and eat it too, as they would if Congress were to repeal the SALT deduction cap entirely.
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