Congress eliminating state and local tax deduction the right move for big growth

States desperately need a return to robust national economic growth in addition to fiscal discipline on the spending side of the ledger. Eliminating the state and local tax (SALT) deduction would provide upwards of $1.5 trillion over the next decade to implement broad-based tax cuts nationally. This overhaul would spur the growth in economic output needed to jolt business investment, personal income growth, and job growth.

Under current law, individuals can deduct state and local taxes (SALT) paid from the amount of personal income subject to the federal income tax. Of course, individuals may also choose to simply subtract a “standard deduction” from their gross income rather than itemize a list of permitted expenses. Approximately 30 percent of taxpayers opted to utilize this SALT deduction, lowering their income subject to federal income tax by nearly $553 billion and thus reducing their federal tax bill by more than $100 billion. Tax reform being considered by Congress will repeal this deduction in exchange for sweeping income tax rate reductions designed to accelerate economic growth and job creation.

What would happen if federal tax revenue generated from eliminating the SALT deduction were used to “buy down” taxes on jobs creators and individual workers? Taking into account the impact of tax policy on the economy (i.e. “dynamic” scoring”), data analysis from the nonpartisan Tax Foundation suggests using a portion of the revenue from ending the deduction to slash the top business income tax rate from 35 percent to 20 percent could generate a net of nearly 600,000 jobs and add $500 billion in annual GDP. In addition, thanks to the economic growth boost, nearly $1 trillion more would remain from the deduction repeal for cuts in other income taxes — generating yet more jobs and growth.

{mosads}How does a revenue-neutral shift in tax policy generate such additional growth? Here’s why. The SALT deduction encourages big spenders at the state level to mask the severity of their fiscal malfeasance; on the other hand, lower marginal income taxes encourage investment and risk taking. Private sector investments yield far greater economic growth than increased government spending. As a secondary effect, a larger economy generates more revenue for governments as well. Maintaining the deduction encourages government overspending and taxation; eliminating the deduction in exchange for lower tax rates spurs growth.

Sadly, a coalition representing a myriad of state and local governmental entities is now screeching that this core component of tax reform is merely a “$1.3 trillion revenue grab by the federal government.” But this accusation conveniently ignores an important fact: all plans under consideration will lower federal income tax rates by an amount designed to ensure that this does not yield a net increase in federal revenue. Far from a “revenue grab,” this is an attempt to eliminate economic distortions in the current tax code.

Opponents also claim that the repeal comes “at the expense of state and local government services and by gutting home ownership incentives.” But the amount of revenue gathered by state and local governments from their existing tax code will actually be unchanged! 

Another common argument is that elimination of the SALT deduction constitutes “double taxation” as a tax upon a tax. This distorts the meaning of the term in an Orwellian fashion. In actuality, double taxation is one governmental identity subjecting an identical income stream to two taxes. Consider the corporate income tax and dividend tax. A corporation is owned by shareholders. The income earned by the corporation is subject to a federal income tax. Payment of this tax diminishes the value of the company as capital is diverted to Washington, DC.

The cost ultimately born by the shareholders as their individual ownership stakes decline in value. This income is taxed again when the company chooses to transfer income to shareholders by way of dividends. Once again, shareholders bear the cost of this tax; but this time they are directly responsible for transferring capital to the government by way of a dividends tax. This is double taxation: an individual paying a tax on the same income twice to an identical governmental entity.

Related to this claim is another baffling statement: “local authority, decision making and budgets would suffer in every state without this deduction” and that repeal is an affront to “federalism.” But nothing within the repeal would restrict the lawful power of state and local governments to impose taxes according to their own constitutions. Perhaps it’s time for the “Big Seven” to actually read the Federalist Papers they enjoy misquoting.

Our Constitution ensures our 50 individual states are sovereign entities — distinctly separate from the federal government. Any power possessed by the federal government is derived only from the consent of the sovereign states as delineated in the U.S. Constitution. Little overlap is intended to exist in the responsibilities of these two realms of government. The federal government bears responsibility for an enumerated list of activities, including the national defense, international relations, interstate commerce, international trade, and monetary policy. All other powers not expressly granted to the federal government in the Constitution are reserved to the states or the people respectively.

What federalism does prevent is one government entity from taxing another. But federalism in no way precludes separate government entities from taxing an individual subject to both jurisdictions. Those who suggest otherwise do so out of ignorance or intentional misrepresentation of our Constitution.

Of course, residents of jurisdictions with high state and local taxes would become more likely to demand lower taxes. And state and local governments would potentially face more opposition to tax hikes, as the SALT deduction would no longer mask the full extent of these tax hikes. This encourages fiscal prudence. One of the most vocal opponents of repeal seems to agree. The Government Finance Officers Association (GFOA) warned, “Taxpayers would not accept a tax increase in taxes paid.” Instead, these taxpayers “would make their displeasure known — especially those in high-tax jurisdictions.” Indeed, this is a positive! Taxpayers in New Jersey, for instance, endure some of the highest taxes in the nation due to decades of mismanagement, corruption, and handouts to public sector unions by those entrusted by the electorate. Additional accountability should be welcomed.

It’s time to stop forcing citizens in fiscally responsible regions to subsidize the malfeasance of politicians thousands of miles away. Indeed, without the SALT deduction, citizens are more likely to hold their local elected officials responsible for government mismanagement. Incentivizing investments in business enterprises and technology by lowering the penalty on success produces far more growth than subsidizing state and local government spending through the SALT deduction.

Joel Griffith is director of the Center for State Fiscal Reform at the American Legislative Exchange Council. Jonathan Williams is chief economist at the American Legislative Exchange Council.