The provision in the new tax reform law capping the deduction for state and local taxes has put some big states in the crosshairs of the Wall Street ratings agencies, where officials fear that the new law will lead to a mass exodus of rich people from certain municipalities and lower state and local governments’ ability to pay down debt, the Fox Business Network has learned.
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The states in the crosshairs: California, New York, Illinois, Connecticut — all places that impose high state and local taxes and where top earners account for the majority of tax revenues.
A significant shortfall in tax revenues could lead to credit rating downgrades in these states and, of course, lower bond prices. According to bond rating house S&P Global, California has an AA- rating, New York an AA+ rating, Illinois a BBB- rating and Connecticut an A rating. Ratings agencies rate bonds on a scale from AAA--top investment grade--to D for bonds that have defaulted.
Under the tax law, no more than $10,000 of state and local taxes can be deducted from filers’ tax bills. The average deduction for state and local taxes — known by the acronym SALT — is about twice the amount currently allowed under the new tax law, according to the Tax Policy Center.
Because the rich pay so much of these states’ taxes, and they can more easily relocate, tax revenues in these hard-hit areas could fall over the next few years as people choose to relocate to lower-taxed states, rating agency officials tell Fox Business.
It’s impossible to know just how many people will relocate when the cap on the SALT deduction kicks in this April. So far, the rating agencies haven’t publicly sounded major alarm bells with major downgrades or dire warnings about the bonds of states where the capping of SALT deductions could lead to a massive flight to states without high state and local taxes.
According to traders, prices of debt issued by California, New York, Illinois and Connecticut have been rising somewhat because municipal debt is tax free, thus investors are snapping up these securities to avoid higher taxes.
But, in interviews with Fox Business, officials at the rating agencies concede that they are concerned about the quality of the debt from these places as the SALT deduction cap takes hold with the payment of 2018 taxes this spring. That concern could mean that these bonds could begin falling in value when the new SALT deduction impacts state revenues, causing budget deficits, bond rating downgrades and, in some hard-hit municipalities, defaults.
Anecdotal evidence abounds that the capping of the SALT deduction is now squeezing budgets in these states. The rich are leaving places like New York and Connecticut for Florida where there is no state income tax. Housing prices in tony areas of Connecticut’s Gold Coast, are starting to fall. Housing prices in the San Francisco Bay area, where many of the Silicon Valley elite reside, have also been falling.
According to analyst Gabe Petek of the rating agency S&P Global Ratings, eliminating SALT deductions also means states have reached the upper limit of how much they might be able to tax remaining wealthy families at a time when they might face budget deficits because of their shrinking tax base.
The new SALT deduction cap, he said, “erodes the ability of some states and/or jurisdictions to raise taxes in the event of fiscal stress, and that could in turn translate to weaker credit quality.”
Rating agency officials tell Fox Business they aren’t predicting wide-spread defaults — at least not yet -- since many big businesses remain located in these places. New York, for instance, is still home to the big banks and Wall Street, and many large and profitable hedge funds are located in Connecticut. California, of course, is home to the nation’s foremost economic dynamo in Silicon Valley.
Yet each of these industries could be facing tougher times. The long bull market in stocks may end, thus depressing bank earnings and the tax revenues they produce for state and local governments. Hedge funds have been closing shop in Connecticut as investors flee to lower-cost products such as index funds and exchange-traded funds, while one of the state’s biggest employers, General Electric, has relocated to Massachusetts.
Silicon Valley firms like Facebook and others confront an uncertain regulatory future as lawmakers from both parties worry about privacy issues. The tech giants often make money through targeted ads based on culling user information, and any legislation that impedes data collection could hurt the firms’ bottom line.
A broad-based downturn in these industries, combined with a flight of wealthy people to lower-taxed states is a nightmare scenario that has bond raters and large investors on edge.
Jeff Assaf, chief investment officer at ICG, believes eliminating SALT deductions “is one of those moments that causes people to say, ‘I’m out of here.’ They reach a point of capitulation and they say, ‘f--- it’.”
Assaf has already seen clients leave California for tax havens like Delaware, Wyoming and Arizona. Assaf notes that many with high incomes already have multiple homes across the country. “If you’re a high-income earner just stay in California less than six months” and switch residency to a state that doesn’t have an income tax, he added.
Indeed, California’s debt may be the most vulnerable to the potential budget impact of capping the SALT deduction since it’s estimated at $1.3 trillion in 2015, the highest of any state in the country. It’s one of only two states (the other being Louisiana) where its rating fluctuated more than five times in the last 20 years and it’s one of only three states in the last decade to drop to an A- rating by S&P Global Ratings.
As the state with the highest income tax rate in America, California also depends on the ultra-wealthy for the majority of its tax revenue: In 2016, roughly 70 percent of California’s general fund revenue came from personal income tax, and 46 percent of that tax was paid by the top 1 percent of taxpayers.
Moreover, California hasn’t prepared for the bad times. In a stress test conducted by S&P, California couldn’t even survive one year of a recession without raising taxes, issuing bonds or slashing services.
The problem will escalate, according to S&P, illustrating California’s “propensity for revenue volatility” in the aftermath of tax reform, the rating agency recently stated.