Republicans on the House Ways and Means Committee have proposed three tax bills under the umbrella titled “American Families and Jobs Act.” It’s impossible to do a comprehensive analysis in this short article. Instead, I focus here on one good thing: it keeps the State and Local Tax (SALT) limit, a key feature of the 2017 Tax Cuts and Jobs Act.
The SALT limit caps the amount of state and local tax that taxpayers can claim if they itemize their deductions. The cap is $10,000 annually for individual taxpayers and for married taxpayers filing jointly. Before the 2017 tax cut law, taxpayers who itemized faced no limit on the amount of state and local tax they could deduct. The change meant that high-income taxpayers who live in states with high income taxes took a huge hit. Even so, most taxpayers gained at least a little because the standard deduction was raised substantially to make up for the SALT limit, and marginal tax rates were cut somewhat for the vast majority of taxpayers.
Of course, politicians from high tax states like New York and California don’t like the SALT limit. So why do I think it’s so good?
There are two main reasons. First, it will rein in wasteful spending by state and local governments. Second, the lower marginal tax rates that the SALT limit allows give people a greater incentive to make income.
For a given amount of revenue raised, the ideal tax system is one that doesn’t give people an incentive to do wasteful things. While none of us, unless we are legislators, chooses how much our state and local governments spend, our resistance to their spending is lower if we can deduct from our taxable income the taxes they impose. That deductibility gives those governments an incentive to do more spending, much of which is wasteful, than they otherwise would. Limiting the deductibility will, especially in the long run, cause taxpayers to question some government spending. As a bonus, it also means that taxpayers in low-tax states are not implicitly subsidizing taxpayers in high-tax states.
The second benefit of SALT is that, for a given amount of revenue raised, marginal tax rates can be lower. The 2017 tax cut reduced marginal tax rates at all income levels. The greater the portion of our additional income we can keep, the higher is our incentive to make more money. Moreover, a theorem in economics says that the distortions due to taxes are proportional, not to the tax rate, but to the square of the tax rate. That makes cuts in marginal tax rates especially valuable.
If we think of higher tax rates as broccoli, then raising or eliminating the SALT cap trades salt for broccoli. Let’s keep the SALT and pass on the broccoli.
August 3, 2023