High-Tax States Fight Back Against Tax-Reform Cuts

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The tax-reform bill became law just in time for the 2018 tax year to start, and there were plenty of controversial provisions that ended up in the final version of the legislation. One of the hardest-fought provisions involved the itemized deduction for state and local taxes, which was initially targeted for complete elimination. In the end, tax reform incorporated a limited deduction of up to $10,000, for both property taxes and taxpayers' choice of either income or sales taxes.

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High-tax states like New York, California, and New Jersey were especially angry at the prospect of losing state and local deductions entirely, and even the concession to allow a limited amount of deductions didn't appease them in full. In response, many states with higher taxes are looking at ways to get around the provisions or otherwise fight the federal government. Some of the ideas on the table are novel, although it's far from clear that they'll actually work.

States to sue the feds?

One strategy that's likely to play out as 2018 begins is the legal theory that limiting the deductibility of state and local taxes is unconstitutional. Gov. Andrew Cuomo (D-N.Y.) said that he believes that the $10,000 limitation is illegal, calling it "the first federal double taxation in history, violative of states' rights and the principle of equal protection." Other states, including New Jersey, Connecticut, and California, are looking at similar legal challenges.

Law professors have mixed views about whether such challenges would succeed. The tax law did a good job of avoiding explicit references to specific states, thereby sidestepping what would have been the clearest constitutional arguments against the changes. Yet defensible theories could still point to the discriminatory impact on geographical grounds. In the end, it seems likely that courts won't be able to force the federal government to change state and local tax provisions.

Changing the way states tax

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A more pragmatic solution involves shifting the way that states and localities impose taxes on their residents. Businesses are still allowed to deduct the costs they incur to employ their workers, and that includes money that state and local governments collect from businesses through employer payroll taxes. These taxes, which are different from the ones that get withheld from employee paychecks, don't directly reduce the amount of money that workers receive, although they can have an impact on prevailing after-tax wage rates in certain areas.

One innovative concept would have state governments offer tax credits in exchange for charitable donations to their coffers. Under one version of such a scheme, according to The Economist, states would give taxpayers a matched credit for contributions to their state treasuries. In other words, for every $1 given, taxpayers would get a $1 credit. The strategy hinges on the idea that charitable contributions remain deductible under tax reform, with limits defined by adjusted gross income rather than under the reform law's $10,000 provision.

The problem with the strategy to allow tax-favored donations to state governments is that such contributions arguably wouldn't be deductible under federal law. In cases in which donors receive valuable compensation in exchange for their donations, they typically have to reduce the deductible amount of their donation by the value of what they receive. If giving $100 gets you a $100 state tax credit, the IRS could easily argue that you don't deserve any charitable deduction at all.

Long-term lessons for tax-policy advocates

Whether or not these moves are successful, the takeaway from those who follow tax policy is that federal rules that establish expected costs or benefits of making tax-law changes almost never consider all the potential second-order impacts of their enactment. If states succeed in circumventing the negative impact of the limitation on state and local taxes, then the higher tax revenue that was supposed to offset the loss of taxes from cuts elsewhere will turn out to have been a mirage. That in turn would perpetuate the lack of credibility that lawmakers on both sides of the aisle have when it comes to meaningful tax reform, with beneficial impacts to American taxpayers on the whole.

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