The American Prospect, January 2, 2018
There is little question that the Republicans in Congress were quite explicitly targeting high-tax blue states with their decision to severely limit the deductions for state and local taxes. Putting a cap of $10,000 on these deductions can add thousands of dollars to the tax bills of many upper middle class people living in relatively high-tax states like California or New York. As a result, these states will feel considerable pressure from a politically powerful bloc to lower taxes, which will then necessitate cutbacks in areas like education and health care.
Fortunately, there are ways to undermine the Republican effort. An obvious one is to partially replace the state income tax with an employer side payroll tax. This can lead to a situation in which the state tax on wage income ends up being fully deductible against federal income taxes even for people who do not itemize on their tax forms.
To take a simple example, suppose a state imposes a flat 5 percent income tax. A person earning $200,000 a year will be paying $10,000 a year in state income taxes. If they also own a home and pay $8,000 to $10,000 a year in property taxes (a plausible scenario in California or New York), the $10,000 cap will drastically reduce the amount they can deduct on their federal taxes.
But suppose that the state changed its income tax to an employer side payroll tax of 5.0 percent. In this case, the person pays zero state income tax on their $200,000 in wages, but their employer pays a $10,000 tax. The standard view among economists is that employer side payroll taxes are passed on pretty much dollar for dollar in lower wages. The argument is that employers care about how much it costs to hire a worker; they don’t care whether they are paying the money to the worker or the government.
If we assume a dollar for dollar pass-through on wages, this worker will see her pay drop to $190,000. This leaves her with the same amount after paying their state taxes as when the state had an income tax, with one big difference. They will only be subject to federal income taxes on the $190,000, not the $200,000 in pay they would have received if the state left its income tax in place. The employer-side payroll tax effectively preserves the full deductibility of the state income tax for workers in the state.
In fact, it makes the deductibility somewhat better since all workers would effectively be able to deduct their tax, even those who don’t itemize. Suppose a worker earns $60,000 and doesn’t have enough deductions to make itemizing worthwhile. This person owes $3,000 with the current 5.0 percent income tax, but must pay federal tax on their full $60,000 income.
If there were instead an employer side payroll tax, their income would fall to $57,000, the same as they would have after paying state income taxes. Now they would only pay federal taxes on $57,000, not the full $60,000 that would have been subject to federal income tax previously. Since they had not previously itemized, this reduction in their taxable income is a pure gain to the worker. If they are in the 22 percent bracket, we just handed this person a $660 tax cut.
There are factors that make the issue more complicated. For example, many high-income people have considerable capital income from owning stock or other assets. There is no reason to change the treatment of capital income in the state tax code. While there may still be some inequities across states by ending the deduction, the just-enacted federal tax changes are very generous to people with large amounts of capital income, so this one need not be a great cause for concern.
Some states have progressive income taxes. It is possible to have a progressive payroll tax, but the easier route would be to put the tax near a midpoint and then have an earned income tax credit (or expanded credit) for workers who would end up paying more under the payroll tax system.
There also is an issue with workers who live in one state and work in another, and with federal employees. (States can’t impose a payroll tax on the federal government.) There are already reciprocal tax arrangements between many states. These can presumably be extended.
Another possibility is to leave the state income tax in place and have the payroll tax serve as a dollar for dollar credit against the tax. That would require a bit more accounting, but lead to the same outcome. There will inevitably be some complications, and undoubtedly some taxpayers will find themselves in a situation where they will be hurt by this plan, but it should be possible to shield the vast majority of people in blue states from the Republican efforts to penalize them for living in relatively high-tax states.
As a general rule, progressives should not be looking for ways to game the federal tax code. After all, we do believe that the federal government has many important responsibilities and this requires collecting taxes, even if we don’t fetishize balanced budgets. But when the Republicans in Congress look to screw states for trying to meet the needs of their people, it is necessary to fight back. A state employer side payroll that undermines their plan is a great way to say “Merry Christmas” to Donald Trump and his supporters.