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Restructuring State and Local Taxes to Maintain Deductibility

  Sanjiv Gupta CPA  Published 
Restructuring State and Local Taxes to Maintain Deductibility

Tax reform is expected to eliminate the local and state deductions. The reason behind this is that it encourages the local and state government to increase taxes. If tax reform manages to eliminate the deduction, then the local and state governments will be facing a bigger and stronger pressure in keeping the taxes low.

Violating Neutrality that is Appropriate in Some Circumstances

The sole purpose of this tax reform is to liberate the economy in order to gain more strength by setting the neutral tax base and is lowered in the tax rates in a revenue-neutral manner. This can also improve the incentives for businesses as well as families along with entrepreneurs and investors that can engage in the activity.

Neutrality’s principle keeps the taxes in such a way that it does not influence the decisions of the taxpayers on an economic basis. By maximizing economic growth, the tax reform can institute this in the neutral tax code at a reasonable level. Nonetheless, there are still some instances that violate the neutrality and is still regarded as appropriate.

Whenever there is an anomaly that is historically unavoidable, then this case is exclusive for the employer-provided health insurance. This exclusion is also a historical artifact that dates back to the 2nd World War. Because by eliminating this, there are other reforms that can create the major disruptions that are apparent in the health insurance market. There are also some sensible tax reform plans that can also retain the exclusion and also provide the credits for the families so that they can obtain health insurance.

A similar instance is when the beneficiary of the specific policy justifies that it is more harmful than neutral. Earned Income Tax Credit is retained so that families that are in the low-income bracket can improve their situation.

Note that tax reforms must eliminate the neutral policies containing negative consequences and intentions. When this is done, then neutrality will be eliminated.

State and Local Tax Deduction is Neutral and Must Be Eliminated

The tax code lets the taxpayers deduct certain local and state taxes that include income taxes and sales taxes specifically for the residents of states. These go without the income tax, personal property taxes and real estate taxes. Local and state income taxes also make up around 95% of all the local and state deductions.

According to the tax policy theory, the reductions are neutral because taxpayers may not have to pay on the income tax that they really do not save or spend. The local and state taxes also deprive the taxpayers allow the ability to do both with the taxes and the income that they can claim.

However, the downside to the theory of the tax policy usually does not keep to what is known information on economic reality. When it comes to the local and state tax deduction is the harmful negative consequences. It also creates the benefit of ensuring the taxpayers that do not pay income tax the reality that they cannot save or spend.

The deduction from this results in another circumstance that warrants and violates the neutrality. This is the very reason why tax reform must eliminate it.

Deduction Encourages the Local and State Governments to Raise the Taxes

The harmful and unintended consequences of the deduction are that it influences the local and state governments to increase their taxes. However, higher taxes also let the local and state governments grow larger because there is a need to spend the maximum amount of revenue that is possible for them to collect.

The deduction also encourages the local and state governments that can raise their taxes because it is possible to transfer some of their tax burden percentages from the residents and to the federal government. For example, every dollar that the state taxes one family that pays the 33% federal marginal tax rate, the family can also effectively pay a percentage. Specifically, this is $0.67 of the state tax. The deduction on the federal taxes of the family reduces the tax bill by $0.33.

This deduction in the mentioned price of the state and its required taxes also influences the states to increase their taxes higher. This is because taxpayers can also offer a lower amount of resistance because they really do not pay the full amount of the higher taxes. Taxpayers are also more willing to accepting the higher taxes due to the deduction that the consumers are willing to purchase a service or product especially when the prices decrease.

However, there is no connected reduction in the federal government when it comes to the revenue from the deduction. The federal government does and can borrow freely. This is why Congress spends amounts of tax revenue that is irrespective. The local and state governments have also less latitude in terms of borrowing in order to spend more that is closely matched to the tax receipts.

If this deduction is removed from the tax reform, then the overall amount that the taxpayers pay in terms of taxes is least likely to not change. Tax reform should be in the form of revenue and distributed in a neutral setting. This means that the taxpayers must pay the same amount of federal taxes as they did before. However, federal taxes can no longer reduce this burden effectively on their local and state taxes.

The taxpayers are now faced with shouldering the burden of local and state taxes. Taxpayers are also more likely to reduce the existing tax burden. By combining these effects, they can restrain the tax burdens on both the local and state government level.

States with the Highest Taxes Would See the Greatest Pressure

The municipalities and states with the highest taxes have the biggest pressure in lowering the taxes of their residents. Taxpayers that are in states with high taxes also tend to have higher incomes. For example, based on a study conducted by the Tax Foundation, Connecticut, New York as well as New Jersey have the highest local and state taxes and burdens. They are also ranked in the top five in regard to the per capita income. The number of high-tax states usually have relatively high per-capita compensation.

Those who are paying higher income taxes can also claim the deduction in the local and state taxes level. According to the IRS, the taxpayers who earn around $100,000 due to the claim can get a 76% deduction.

Data shows that taxpayers who are residing in states with high taxes usually already pay hefty amounts on the local and state taxes. There is also a burden that is reduced through the deduction. If tax reform manages to eliminate the deduction, then the taxpayers can see a big increase in both their local and state taxes. They can also put pressure on these government ordinances in order to stop the increase in taxes and allow them to apply pressure on them so that higher taxes can be reduced.

Lower Rates are an Added Bonus

By eliminating the local and state tax deduction can only be done when it is within the context of the tax reform as an overhaul. Congress must not eliminate this without offsetting the changes in the taxes. In order for them to do this, then there would be unnecessary increases in taxes.

Eliminating the deduction in the total revenue whether it be in a neutral tax reform can also allow the marginal tax rates to be lowered for families. The local and state deduction can also reduce the taxes to $1 trillion over 10 years. Revenue can also be provided for the substantial and additional reduction in the rates. If the rates are lower, then it also enhances the growth-promoting potential of the reforms in taxes. This is also an added bonus when the deduction is eliminated.

Eliminating State and Local Tax Deduction in Order to Pay for Tax Cuts

The tax plan that President Trump and the congressional Republican ends the federal deduction that is allotted to SALT or the state and local taxes. This lets the taxpayers itemize their deductions on the income taxes from a federal level and also deduct the local and state taxes. There are proponents that argue that when this deduction ended, it will not hurt middle and low-income households because the direct benefits are targeted to the higher-income filters. By eliminating this deduction, the federal income tax will eventually become more progressive. However, it also ignores that the actual tradeoff of the GOP tax plan is proposed. This eliminated the SALT deduction and then resorts to the revenue so that the marginal income from these tax rate cuts can be bad for most Americans, particularly those who are considered to be middle and low class.

The first thing to know is that the rate cuts in the tax plan tend to be tilted especially concerning the SALT deduction. This is the reason why the year 2027, 80% of the net tax cuts are shifted to the top 1 percent of the Americans. This is when they claim that the key elements of the current plan will completely take into effect. The Tax Policy Center has estimated this.

Secondly, the SALT deduction assists the local and states funding, especially in the public services. They provide widely shared benefits. Because this deduction is of a high income and a number of people are willing to support the taxes on the local and state level, then repealing this deduction can definitely make it harder for both the locality and the state.

When the deduction is repealed and rejected, then it is harder for the localities and the states to tackle the budget strains. It raises sufficient revenues especially in the coming years for the government to fund higher education, including K12, and above all, health care. In order to balance the budgets with revenue that is insufficient, the policymaker of the state likely makes cuts in particular services that would make it almost felt. It would also push the costs to the low and middle-income people, making the local and state tax systems and make it more regressive in the over-all setting.

States and localities can also respond when raising the fees and taxes that fall heavily on the residents who are within the higher-income bracket. It would also push the costs into the low-and middle-income individuals and make the local and state tax systems more regressive than it already is.

The proposal to end SALT deduction and make it harder for localities and states to fund the current programs that they have in mind allowed the President and the Republicans to come up with a proposal of a 10-year budget that shifts the substantial and new costs to the states. It also sharply cuts the Medicaid and other funding of the health insurance and potential cuts the federal support for the local and state services such as transportation, low-income housing, education, and environmental protection.

Responding to the criticism of the Republican representatives of Congress who also represent varied states could be a particularly difficult approach if the intent is to end the SALT deduction. GOP leaders have considered a number of compromises that would partly, as opposed to entirely, end it. These also include capping the deduction and then ending that for the income taxes and not the real estate taxes. Letting the filers take the SALT deduction or another like interest deduction and home mortgage. Both cannot be taken. Partially ending this new deduction process is particularly harmful to middle and low-income Americans. However, since the states and localities will eventually weaken, then it is time to increase the adequate revenues.

Trump administration officials pointed out the estimates that show most of the deductions from SALT on the federal tax benefits go to people earning $100,000. Higher-income filers can also benefit more depending on the deduction because these are likely to be itemized, claim the higher amounts of the deductions, which also include the SALT, and resort to higher federal tax rates.