Next Tax Battle: Trump's Bid to Axe a Favorite -2-

A big tax break skewed toward Democratic-controlled blue states is the next major battleground as President Donald Trump and congressional Republicans attempt to rewrite the tax code.

The tax policy outline Mr. Trump unveiled Wednesday proposes repealing the deduction for state and local taxes, which lets individuals subtract their home-state levies from their federal taxable income. That move was a major shift for Mr. Trump, who previously had called for capping deductions but not killing the break.

What makes the latest proposal politically divisive -- and could lead to a split inside the Republican Party -- is that it would shift the tax burden from low-tax states such as Texas and Florida to high-tax states such as New York and New Jersey. Blue-state Democrats criticized the proposal, as expected, but Republicans from those states don't like it either.

Congressman Peter King (R., N.Y.), who represents part of Long Island, says he is on board with the GOP's philosophy eliminating tax breaks and cutting rates, right up to the point where it thwacks his constituents and their ability to subtract $12,000 annual property tax bills from their federal income.

"I am a Jack Kemp Republican," he said in a recent interview. "I believe in supply-side economics. I'm all for that. But again, this has a unique hit on Long Island."

In the weeks leading up to the White House's announcement, Mr. King, New York Democrats and business groups had been urging Republican leaders in Congress to back off their proposal to repeal the deduction. Instead, the administration -- in which the president and his two top economic advisers are high-income residents of blue states -- chose repeal.

"I never thought I could leave New York and go to a state that had higher taxes, but I did when I moved to California," Treasury Secretary Steven Mnuchin said at a Wednesday morning briefing before justifying an end to a major break for New Yorkers and Californians. "We want to get the federal government out of the business of what's the states' business."

Republicans focused on lowering marginal tax rates have been targeting the deduction unsuccessfully for decades. They contend that it props up bloated state and local governments with support from federal taxpayers. Repealing it, they argue, could put pressure on states to limit or reduce spending and taxes.

Removing the deduction could raise more than $1 trillion over a decade, according to independent estimates, which would help offset the cost of GOP rate cuts.

The deduction, one of the largest breaks for individuals, saves taxpayers about $103 billion this year, according to the congressional Joint Committee on Taxation. That is $38 billion more than the mortgage-interest deduction and $46 billion more than the deduction for charitable contributions.

Without repealing the deduction, Republicans would have to settle for smaller tax-rate cuts, higher budget deficits or temporary tax policies. They will be constrained by congressional rules that prevent them passing a tax plan on a party-line vote in the Senate unless they refrain from increasing budget deficits beyond a decade.

Democrats mobilizing to defend the deduction are in the awkward position of standing up for a tax measure that helps some of the highest-income Americans -- the same people they typically say don't pay enough in taxes. To win, they will need to transcend party politics by appealing to hometown interests. During the 1986 tax code overhaul, a coalition of business groups, state officials and blue-state Republicans protected the same tax break.

Administration officials argued this week that it isn't the federal government's job to be subsidizing states, though the federal government does redistribute income across state lines outside of the tax system.

"We also think about being fair. We're being fair," Gary Cohn, the director of Mr. Trump's National Economic Council, said at the briefing with Mr. Mnuchin. "And there are those that argue that allowing state and local taxes to be deductible is not fair because certain states are subsidizing other states, and this is a field-leveler."

At the center of the fight is New York, home of Mr. Trump, Mr. Cohn and Senate Democratic Leader Charles Schumer, who says killing or scaling back the break would be "devastating for middle-class families in New York and elsewhere."

In New York, the deduction equals 9.1% of adjusted gross income, the highest in the nation, according to an analysis of government data by the Tax Foundation, a Washington group that favors a simpler, flatter tax system. New York residents thus face a particularly heavy state tax burden, which gets mitigated by the deduction.

The Republican tax plan is "very anti-New York in many ways," says Rep. Joseph Crowley, a Democrat from Queens. "It's going to cost more for New Yorkers. It's going to be more federal taxes for them. And that simply isn't right."

Repealing the deduction, before taking into account other changes in the GOP plan, would raise taxes on about 27% of New York households, increasing their federal bills by an average of $4,250, says the Tax Policy Center, a joint project of the Urban Institute and Brookings Institution. In New Jersey, 32.9% of households would see their federal taxes go up if the deduction were repealed, with an average increase of $3,522. Similar increases would happen in Maryland, Connecticut, California and Massachusetts.

The proposed reduction of individual tax rates and repeal of the alternative minimum tax would temper those hits. High-income households subject to the alternative tax already can't take the state tax deduction. Overall, the Trump plan would mean big tax cuts for many high-income Americans, but some households might still see tax increases. Congress and the White House haven't released enough details to make full calculations.

Rep. Kevin Brady, the Republican chairman of the House Ways and Means Committee, contends that repealing the break leads to equal treatment of residents of high-tax states and low-tax states. He hails from Texas, which doesn't have a state income tax and where individual deductions for property and sales taxes make up just 2.5% of income, near the bottom of the pack.

"It is a sort of a fresh approach to moving away from having deductions for some, usually wealthy, or those in high-tax states," he says. The goal, he says, is to make sure that "Washington doesn't reward or punish you based on where you live or choose to live."

Defenders of the deduction have a different view. Though blue states benefit from the deduction, they contend that red states get a lion's share of federal spending on the military and government benefits for elderly and poor households.

Kathryn Wylde, chief executive officer of the Partnership for New York City, a group that represents the city's biggest businesses, says the tax break helps the broader economy by supporting an agglomeration of media, finance, accounting and professional-services jobs. She worries about a populist backlash against "clusters of very high earners in the nation's economic centers."

The state and local tax deduction is one of the oldest breaks in the U.S. income tax, dating back to an 1862 tax on incomes imposed by the federal government to finance the Civil War. It has proven resilient, reappearing with the 1913 imposition of a federal income tax and surviving the last tax-code shake-up in 1986, when President Ronald Reagan tried to repeal it.

Democrats controlled the House in 1986, and Ways and Means Chairman Dan Rostenkowski of Illinois forged an alliance with New York Republicans.

James Baker, who was Mr. Reagan's chief of staff and then Treasury Secretary, said the deduction was the only subject that caused Mr. Rostenkowski to hang up on him.

"We had a little shouting match, and it was just one of the deductions that they were damn well determined to protect," Mr. Baker said in a recent interview. "We ended up having to let it go."

The break is an itemized deduction. That means most households don't use it. To claim an itemized deduction, total deductions -- largely for mortgage interest, charity and state and local taxes -- must exceed the standard deduction of $6,350 for individuals and $12,700 for married couples. Mr. Trump wants to double the standard deduction, so many middle-income households might not feel the pinch of the lost break because it would be covered by the bigger standard deduction.

Just 30% of U.S. households itemize their deductions. Those who do -- people who benefit from the state and local tax break -- are concentrated in high-income, high-tax states. More than 90% of filers with incomes over $200,000 claim the deduction, according to the Tax Policy Center. Overall, 38% of the deduction's value goes to California, New York and New Jersey, which have 21% of U.S. households, the center says.

The top nine states for the deduction, measured as a percentage of income, all voted for Hillary Clinton, and they have 18 senators, all Democrats. In the House, those same states have 33 Republicans, a number that exceeds the party's overall governing margin. That means they have the numbers to protect the break -- if they all agree on the policy and use their leverage.

New York and New Jersey Republicans already resisted the GOP leadership's health care bill in March. Rep. Dan Donovan of Staten Island, N.Y., says losing the deduction would "crush" his constituents, and Rep. John Faso of Kinderhook, N.Y., says it would be "double taxation." Rep. Tom Reed of Corning, the lone New York Republican on the tax-writing Ways and Means Committee, says he intends to fight to protect the break.

Mr. King of Long Island says he spoke out against repeal during House Republicans' January retreat in Philadelphia. His district, he says, is full of police officers and firefighters whose biggest asset is their house, and losing the ability to deduct property taxes could hurt home values.

"This is really bread and butter. This is blood and guts," he says. "The Democrats will run wild with it."

New York, in a 2013 report by Gov. Andrew Cuomo on the "tax threat" to the state, called repeal of the deduction and other potential federal changes an "unfair double taxation scheme" that would adversely affect New York. State residents who are used to taking the tax break would have to pay the full New York tax -- with a top rate of 12.7% in New York City and 8.82% for the state outside the city -- on top of their federal income taxes.

For the very highest-income New York households -- think Wall Street bonuses -- loss of the deduction would make the full cost of being a state resident more apparent than ever. That could increase the incentive for individuals to move away and for businesses to pick another state.

"If you talk to the very wealthy and hear them talk about their tax burdens, they're conscious of the difference between being here and being there," says E.J. McMahon, research director of the Empire Center for Public Policy, a conservative policy think tank in Albany.

There isn't much evidence that high-income households move because of state taxes on individuals, says Kim Rueben of the Tax Policy Center. The exceptions are retirees who don't need access to high-paying jobs in states like New York and may be looking to move to a state without an estate tax.

The lawmakers to watch in coming weeks are the blue-state Republicans in the House, including Rep. Chris Collins of New York, an early supporter of Mr. Trump. He said Wednesday that repeal is a "big concern" for GOP lawmakers from New York, New Jersey and California.

"Ever since our proposal first came out in January, I said I will fight to keep those deductions," he said.

--Janet Hook contributed to this article.

(END) Dow Jones Newswires

April 27, 2017 12:56 ET (16:56 GMT)