TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Saturday, November 4, 2017

Weekly SSRN Tax Article Review And Roundup

This week, David Gamage (Indiana) reviews a new draft paper by Daniel Hemel (Chicago), Easy on the SALT: A Qualified Defense of the Deduction for State and Local Taxes.

Gamage (2019)Prompted — at least in part — by Congressional Republicans’ recently released tax reform proposals, Daniel Hemel has written a thoughtful new piece on the state and local tax (SALT) deduction. Although Hemel’s paper is currently in preliminary draft form, this draft is nevertheless well worth a read for anyone interested in taxation at either the federal or state levels in the United States.

Hemel thoughtfully reviews arguments both for and against the SALT deduction, concluding that “the case against the SALT deduction fails on its own terms, and that the status quo of partial deductibility offers a number of underappreciated advantages vis-à-vis the alternative of full repeal.”

Hemel summarizes the arguments against the SALT deduction by grouping them into five categories: “First, the deduction narrows the federal tax base, meaning that Congress must impose higher marginal tax rates (leading to larger deadweight losses) in order to meet its revenue goals. Second, the deduction reduces the after-tax price of goods and services supplied by states and localities relative to goods and services supplied through the market, thus leading to overprovision of goods and services by subnational government. Third, the deductibility of some but not all payments to states and localities distorts those governments’ choices among tax instruments. Fourth, the deduction disproportionately benefits high-income households and so makes the overall tax system more regressive. Fifth, the deduction leads to inequities across jurisdictions, with low-tax states effectively subsidizing higher-tax states.”

Hemel’s paper offers worthwhile analysis in regard to all of these categories of argument. I agree with many, but not all, of his conclusions. Yet, to limit the scope of this review, I will limit myself here to discussing just his analysis of the the third category of argument—that “the deductibility of some but not all payments to states and localities distorts those governments’ choices among tax instruments.”

In analyzing this argument, Hemel first discusses the possibility that repealing the SALT deduction would cause states and localities to substitute business-level taxes (which would remain deductible under the Republicans’ plan) for individual-level taxes (which would mostly no longer be deductible). Darien Shanske and I have previously explained how the current structure of federal tax law already causes state governments to over rely on corporate income taxes, both as a means for raising revenue and as a method for funding targeted tax incentives aimed at mobile businesses. Hemel’s point is that repealing the individual-level SALT deduction — while retaining the business-level deduction — would magnify these distortions.

Of course, Hemel acknowledges that “the status quo already distorts state and local government decisions regarding revenue-raising to some degree. States and localities have an incentive to choose either income taxation or sales taxation even if the optimal system would involve a mix of both. They have an incentive to avoid selective sales taxes (such as on alcohol and tobacco) even when those taxes might be consistent with Pigouvian prescriptions.” Even though, as Hemel argues, subnational governments face constraints on completely substituting one form of taxation for another, these constraints do not prevent subnational governments from substituting amongst different forms of taxation at the margin. Darien Shanske and I have previously estimated that these sorts of marginal distortions induced by current policy are very harmful.

Again, Hemel acknowledges that current policy causes these sorts of harmful distortions. His counterargument is “that repealing the deduction for nonbusiness taxes while sticking with the status quo for business taxes simply replaces one federally induced distortion for another.”

Hemel’s point here is valid in relation to the prong of the Congressional Republicans’ recently released tax reform proposal that would repeal only the individual-level SALT deduction and not the business-level deductions. However, Hemel’s argument suggests that the flaw in this reform proposal is that it does not go far enough. The proposal should perhaps be modified so as to repeal (or at least revise) business-level deductions for certain state and local taxes as well as the individual-level SALT deductions. Along these lines, Darien Shanske and I have previously argued that, “[a]s a supplement to reforming the SALT deduction, the federal government might also end the deductibility of state corporate income tax payments against the federal corporate income tax base.”

In addition to arguing that the Congressional Republicans’ proposal for repealing the individual SALT deduction would distort state governments’ choices as to “Business vs. Nonbusiness Taxes”, Hemel also argues that the proposal would distort state governments’ choices as to raising tax revenues “Now vs. Later.” As he explains, “[i]f states and localities expect that the SALT deduction will be restored in the near or medium term, then they will have a strong incentive to borrow today so as to defer tax collections to a time when payments will be deductible.”

This argument of Hemel’s is valid to an extent. Yet, as I and others have previously explained, state and local governments face serious limitations on their ability to increase borrowing. I am thus skeptical that repealing the SALT deduction would have much of an effect in terms of increasing borrowing by state and local governments in the manner that Hemel imagines.

To conclude, I will briefly address the broader question of whether the SALT deduction should be repealed. My view is that this question cannot be answered in the abstract; the answer ultimately depends on how the federal government would use the funds generated by repealing the SALT deduction and what other reforms might be packaged with the SALT deduction. Were I to be offered an up-or-down vote on whether to simply repeal the SALT deduction, with a guarantee that the funds so generated would be dedicated to reducing the federal deficit, I would eagerly vote for repeal. But the question is far more complicated when the funds are likely to be used for other purposes, many of which I consider to be worse policies than the SALT deduction.

As Hemel argues, the distributional impact of repealing the SALT deduction cannot be analyzed without knowing how the funds so generated will be used. I think the same is true when evaluating efficiency, non-distributive fairness, and other policy goals related to the SALT deduction. Were I to propose a tax reform package of my own, I would definitely call for either repealing or dramatically revising the SALT deduction. Nevertheless, I am largely ambivalent about the proposal to partially repeal the SALT deduction in its current form as a prong of the Congressional Republicans’ recently proposed tax reform plan.

Here’s the rest of this week’s SSRN Tax Roundup:

David Gamage, Scholarship, Tax, Weekly SSRN Roundup | Permalink