TaxProf Blog

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

Wednesday, December 6, 2017

Volokh: With State Income Taxes No Longer Deductible, Will States Switch To Payroll Taxes?

Eugene Volokh (UCLA), Now That State Income Taxes Aren’t Going to be Deductible, Will States Switch to Payroll Taxes?:

[S]ay California replaces the state income tax (at least for employment income) with a state payroll tax that’s paid by the employer, and that it comes in at the same amount per employee. As I understand it, the payroll tax — like most other business expenses, such as salaries paid to employees — is deductible by the employer; and it’s not taxable income for the employee, because it’s not the employee’s income. ...

That’s how I understand the thinking of University of Chicago professor Dan Hemel, who wrote about this last month: ...

States like New York and California could impose an employer-side payroll tax pegged to the top marginal rate in the state and allow individuals to claim a refundable credit against state income taxes equal to the payroll taxes paid on their behalf.

The key point here is that a state, through a relatively straightforward legislative maneuver, could entirely negate the effect of the House or Senate proposal with respect to state and local income taxes paid on wage income (which is more than two-thirds of all household income). And given that this maneuver would make state taxes excludible for non-itemizers as well, the net effect could even be to lose money for the federal government.

One might ask why states don’t do this already. Even under current law, there are several advantages to states if they raise revenue through payroll taxes rather than personal income taxes: lower Social Security and Medicare taxes for all wage-earners; avoidance of the alternative minimum tax and the effects of the Pease provision for high earners; and exclusion of state taxes for workers who take the standard deduction. While it’s a bit of a mystery, the best explanation is probably that the benefits aren’t yet enough to motivate states to rearrange their tax systems, given that the people who pay the lion’s share of state income taxes are itemizers who can claim the SALT [that’s state-and-local-tax] deduction. Take away the SALT deduction for income taxes, though, and suddenly the motivation to shift away from a state income tax and toward a state payroll tax becomes much more powerful.

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A payroll tax would accelerate the exit of companies to other lower tax states.The fed
would not lose but,gain revenues.

Posted by: Ed | Dec 6, 2017 6:00:48 AM

It would be easy for Congress to amend the Tax Code to close this loophole. You always have to think about the other player's reaction. (In this case, reaction to your reaction to his action).

Posted by: Eric Rasmusen | Dec 6, 2017 6:19:28 AM

In a world with zero transaction costs and in which employers and employees have perfect information, this workaround would do the trick. Alas, that's not the world we live in.

Posted by: Jonathan H. Adler | Dec 6, 2017 6:24:02 AM

Unless I'm missing something here, I believe the response to the change would be that the employer would lower salary to compensate for the tax savings the employee makes. That leaves the change neutral from the employer's perspective but tax-advantaged from the employee's perspective because of the reduction in rates. So, this wouldn't propel a move to lower-tax states.

Posted by: Greg | Dec 6, 2017 10:52:32 AM

Ed's comment is misguided. The cash flow implications for an employer would be neutral, since the payroll tax would just be replacing withholding. The employer's cost would remain the same. The payroll tax would actually provide a benefit in terms of retaining companies since it provides a benefit to employees.

Posted by: Victor Thuronyi | Dec 6, 2017 11:28:05 AM

Since CA wage earners currently pay state income tax at marginal rates from 0% to 13%, just what should the payroll tax rate be?

Posted by: Jay wiedwald | Dec 7, 2017 8:33:27 AM

@Jay: the payroll rate would be about 9%, but it doesn't matter because the taxpayer would be refunded any excess or pay any shortfall.

"...allow individuals to claim a refundable credit against state income taxes equal to the payroll taxes paid on their behalf."

Posted by: AMTbuff | Dec 7, 2017 9:39:11 AM