What is SALT really about?

Here is the proper way to understand the SALT issue—whether State and Local Taxes should be deducted from taxable income on which federal taxes are levied.

Assume that taxpayer 1 (Jack) in state A and taxpayer 2 (Mary) in state B both have earned incomes of $150,000 each. If Uncle Sam needs to raise $60,000 each year from its income tax and applies a flat tax on each taxpayers’ total income, it would need to impose a tax rate of 20% (150,000+150,000=300,000*0.2=60,000). Each taxpayer would pay $30,000 in federal taxes.

Assume that Jack chooses to buy an expensive car costing $100,000 while Mary makes a more frugal choice and buys a $40,000 car. No one would think that they should be allowed to deduct the cost of their cars from their incomes for purposes of their federal income tax, but what if they could? Jack would now have $50,000 in federally taxable income (150,000-100,000) while Mary would have taxable income of$110,000 (100,000-40,000). To raise the same $60,000 needed by the Feds, the federal tax rate would need to be increased to 37.5% (50,000+110,000=160,000*0.375=60,000). Of the $60,000 in federal tax revenue, Jack would pay $18,750 (50,000*0.375) and Mary would pay $41,250 (110*0.375). Not only does Jack get a better car but he also pays less taxes. In fact, this tax treatment subsidizes Jack’s expensive car to the amount of $11,250 (30,000-18,750). This is likely to lead Jack to buy a more expensive car than he would have chosen if spending only his own money. Clearly that would be neither fair nor economically efficient.

Replace “car” in the above example with “state government expenditures”. Jack may well choose to have (and pay the higher taxes to finance) more extensive state government services than does Mary. That is fine as long as you are free to choose whether you live in state A or state B. But should Mary be forced to pay (subsidize) some of Jack’s tastes for larger state government expenditures? Surely not, but that is exactly what allowing tax payers to deduct their SALT from their taxable income for federal tax purposes does. Eliminating that deduction would restore fairness and remove any artificial inducement for larger state expenditures. In this way, every one would be free to support the level of state spending they are willing to pay for.

About wcoats

Dr. Warren L. Coats specializes in advising central banks on monetary policy, and in the development of their capacity to formulate and implement monetary policy. He is retired from the International Monetary Fund, where, as Assistant Director of the Monetary and Financial Systems Department, he led missions to over twenty countries. Before then, he served as Visiting Economist to the Board of Governors of the Federal Reserve System, and to the World Bank, and was Assistant Prof of Economics at the Univ. of Virginia from 1970-75. Most recently he was Senior Monetary Policy Advisor to the Central Bank of Iraq; an IMF consultant to the central banks of Afghanistan, Kenya and Zimbabwe; and a Deloitte/USAID advisor to the Government of South Sudan. He is currently a member of the Editorial Board of the Cayman Financial Review and until the end of 2013 was a member of the IMF program team for Afghanistan. His most recent book is entitled "One Currency for Bosnia: Creating the Central Bank of Bosnia and Herzegovina."
This entry was posted in Economics, taxes and tagged , , , , , , . Bookmark the permalink.

22 Responses to What is SALT really about?

  1. Gary Phillips says:

    It seems to me that this blog oversimplifies matters in a number of critical respects: (1) The suggestion that the SALT deduction results in a subsidization by taxpayers in low tax states of those in high tax states ignores the spending side of the equation. The fact of the matter is that many of the local tax states that are purportedly subsidizing high tax states receive disproportionate amounts of federal support. So, it is fair to say, they can artificially suppress SALT because of this subsidy. When this consideration is taken into account, The argument that the deductibility of SALT causes low tax states to subsidize high-tax states vanishes. (2) while the blog acknowledges the difference between choosing a car and choosing where one lives, it doesn’t consider the implications of that point. One has full flexibility to decide which car to purchase. But few taxpayers can dusrupt their lives and move to another state. This is true for all the obvious reasons, as well as the possibility that the elimination of SALT deductions in high tax states may make selling their residence untenable or impracticable. As a result, I think it is folly to compare decisions on where to live to ordinary commercial transactions. There will be real and unavoidable economic consequences to real people who are losing the SALT deduction. That should not be lost in this discussion. Nor should anyone lose sight of this ugly fact: the SALT deduction would not be on the chopping block if it did not primarily implicate blue states. The elimination of this deduction reflects corrupt politics at its worst – making tax policy to benefit political constituents and hurt political opponents.

    • wcoats says:

      Gary, Federal transfer payment certainly flow from higher income to lower income people (and thus on average from NY, CA, etc) to Alabama etc. But we are talking about the revenue (tax) side and the effect of SALT deductions and even more so interest deductions (especially mortgage interest) on tax payers. These deductions (by them selves, which is what is relevant when evaluating and designing tax systems) clearly transfer money from lower to higher income people. I find that indefensible from a fairness perspective but it also distorts resource allocations making the economy less efficient.

    • Ken says:

      “But few taxpayers can dusrupt their lives and move to another state.”

      What a crock. Not wanting to =/= unable to. In other words, people CHOOSE where to live, particularly the high income earners. High income earners are easily the most mobile AND the ones who purposefully decide to live in high tax states, expecting high income earners in low tax states to subsidize them.

      Moving is as easy as people make on themselves. If you really want it to be hard, you can pretend and make it very hard. In reality, moving is as easy as getting some boxes, a little time packing, then loading up a truck. It really is that simple. Selling a house isn’t that big of a deal either. Millions of homes are bought and sold every year. I have moved nearly two dozen times in my adult life. I don’t like moving that much anymore, but not wanting to, since I like where I live, but I know it’s as easy if that ever changes.

      Your excuse is no different from the smoker claiming it’s hard to quit smoking, when it’s as simple as not having another cigarette, or the fat guy who claims it’s hard to lose weight, when it’s as simple as stop eating junk food and stop over eating. Everyone can come up with excuses to not do anything and continue their own bad habits.

      Don’t you ever get tired of your own BS? I’m tired of it. And don’t want to pay for it anymore. It’s time for you to pay your fair share.

    • tomdperkins says:

      ” Federal transfer payment certainly flow from higher income to lower income people (and thus on average from NY, CA, etc) to Alabama etc. ” by wcoats

      And those transfer payments were generally voted for moreso by inhabitants of the “blue” areas. Strange for them to be complaining about them existing.

    • Hamilton Beach says:

      “[SALT] reflects corrupt politics at its worse”

      That’s a bit overwrought. Put aside any GOP vs DNC tribalism and the remaining fact is that SALT rewards wasteful state and local governments at the expense of frugal ones.

    • Law of Self Defense says:

      Welcome to the America that Progressives shoved down our throats. “Everything within the state, nothing outside the state, nothing against the state.” Progressive fascists made politics everything, even bathrooms and cakes and happening to be born with white skin. We warned you that you’d hate living by these new rules. I hope you all choke on it, as we’ve had to.

    • Robert Arvanitis says:

      People in high-tax states presumably get high, un-taxed benefits for their taxes (social services, infrastructure, all the rest, tax free).
      We say “presumably” because the high-taxers don’t always spend those taxes wisely. Giving money to politicos is worse than buying an expensive car, because you can always bring a lemon back to the offending car dealer, but you are stuck with a lemon politico.
      High-tax/high-benefit states will be just fine. So too will low-tax/low benefit states.
      The ONLY ones harmed are politicos in high tax/low benefit states, who get thrown out as the rascals they are. And note that this in fact BENEFITS the citizens of such states!

    • John Russell says:

      “But few taxpayers can dusrupt their lives and move to another state.”
      Hillary Clinton states the exact opposite.
      Hillary Clinton says there is one possible solution to joblessness — but it’s a tough pill to swallow. In “What Happened,” Clinton writes that the possible solution is one few people want to discuss.

      “As hard as it is,” she writes, “people may have to leave their hometowns and look for work elsewhere in America.”

      Talking out of both sides of the neck…

      • wcoats says:

        The point is that the level of state expenditures and services and thus taxation generally, broadly reflects the preference of the people living there. That is as it should be (as long as they are the ones paying for it).

  2. Joe Cobb says:

    The “social justice” claim about higher tax rates for more advantaged families and lower taxes for more distresses families also plays against the SALT. Every taxpayer gets at least a Standard Deduction, and itemizations for deduction on Schedule A must exceed that number to be of any value to any tax paying family.
    Look at the “distribution analysis”: only very wealthy taxpayers will use this SALT feature. More than 90% of all taxpayers will have no use for it. The same can be said for Mortgage Interest itemization: only wealthy people live in large, high-appraisal homes. A gift for the most “unworthy” people, according to “social justice.”
    (Note: Hayek wrote that you can put the word “social” in front of any noun signifying a valid concept and convert the phrase “social xxx” into complete nonsense.)

  3. Ed Snack says:

    Gary, you make a huge and unwarranted leap in your claim that the argument vanishes. There’s a small offset, but the argument remains completely valid. High tax states simply cannibalize federal revenue at the expense of low tax states and the deduction should be entirely removed.

  4. Brad says:

    One doesn’t have to leave their state. They can move around within that state as well. I have two friends who work for LA County. They moved 45 minutes outside of work precisely for the lower taxes. It happens all the time, so leaving the state is a little extreme. I moved from the city to the country for just that reason. Went from a postage stamp of a yard, and a 3 bedroom brick ranch, to 2.5 acres, and an extra 500 square feet for the same price. Taxes are about 200 less a month, and I get to decide if I want to burn leaves, have a bonfire, shoot a gun, or have a loud party, without asking permission from some bureaucrat.

  5. reliapundit says:

    Simple fix: phase out the deductibility: 75% deductible in 2018; 50 in 2019; 25 in 2020. Reduce the corporate tax to 23%, which is the global average; (with our labor force and low energy costs we do not have to have the lowest corporate tax rate to attract investment and enterprise.)

  6. jb says:

    “this ugly fact: the SALT deduction would not be on the chopping block if it did not primarily implicate blue states.”

    Sucks playing by the same rules huh?

  7. Roscoe Pilsner says:

    The real difference here is that this deduction has already been baked into the mix. Housing is more expensive (valuable) because the interest deduction has allowed people to bid higher for real estate.

    Anyway, the only valid way of looking at this is in the context of the totality of the entire tax formula…the standard deduction, the elimination of the AMT, how it is phased in, how much SALT is going to be allowed (when does the limit kick in?), etc.

    Only after a person is able to run his own taxes will he ever know what the effect will be on him.

  8. bflat879 says:

    I prefer to look at it as Republicans have figured out a way to tax the rich, without raising taxes and the Democrats are really upset about it. By doubling the standard deduction the average middle class tax payer will get more money in their check or a refund check.

  9. Herb in middle VA says:

    If your analysis is correct, which I believe, then we should see an acceleration of the rich moving to states which have lower tax rates. More large liberal cities will start to become Detroit.

  10. ss396 says:

    Under scenario #1, both Jack and Mary had after tax disposable incomes of $120,000.
    Under scenario #2, Jack had after tax disposable income of $31,250, and Mary had after tax disposable income of $58,750. Even with her higher taxes, Mary is financially better off than Jack with his fancy car.

    How does this provide an incentive for Jack to go after an even more pricey model? Has he no other expenses in his life?

    These kinds of analyses always focus only on the tax, but overlook the net disposable income – the cash you need to deal with the rest of what’s going on in your life. The write-offs are against income, not taxes. Your tax savings is only the amount of the marginal rate applied to that write-off. For example, at a 25% tax rate, you have to spend $4 to save $1 in taxes. That’s $3 that you no longer have for your own enjoyment. How is this a “tax advantage”?

    Don’t get me wrong – I am not fond of paying a dime more in taxes than I absolutely have to, and I want to use every write-off that I can. But I don’t kid myself that paying higher taxes in order to write them off is somehow a “savings”.

    I wish folks would look at a larger picture than just the taxes side of it.

    Meanwhile, why does no one talk about the subsidy of the increased standard deduction? Nearly everyone who uses it will have personal deductions less than the standard, so they are being given “free” deductions in the amount of the difference between what they’d be able to itemize vs. what they can now claim. This raises the tax rates, too. Why isn’t that being touted as unfair to everyone who itemizes?

  11. Jeff K says:

    Love the analysis. Rich liberals want higher taxes on the rich. The removal of deduction of state and local taxes is a tax increase on rich liberals in high tax states. It is like a drone strike on the exact people who want higher taxes for rich people (ie rich liberals) and they are complaining about it. Hysterical. Less hysterical, I am conservative in a liberal high tax state (ie collateral damage).

  12. Seabiquit says:

    I pay taxes in Oregon and will probably have most of the impact reduced by lower federal rates. What will happen is higher income, more influential residents will have a greate4 incentive to advocate less state spending.

  13. Jack Hagan says:

    This is a very nice attack on the Marxist states. Bravo. Hope it works. California and New York need a beating. All the rest of the talk is just bs.

  14. MaxDamage says:

    At one point we thought we were following a better class of leaders, people worth following. Today we’ve elected and seem to be following the remnants who couldn’t get elected to an HOA and had so many skeletons in their closets it looks like a convention.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s