America’s first flirtation with federal income taxes occurred during and just after the Civil War (1861–1872). The tax system back then was pretty simple, with only one deduction available to taxpayers: the state and local tax (SALT) deduction. While records of why this deduction was put into place are scarce, statements by Congressional Republicans at the time pointed to two justifications: trying to keep the federal tax out of the orbit of pre-existing state taxes, and trying to prevent “double taxation.” They wanted to keep the federal government from taxing income that had already been taxed by the states. Other than a very short return from 1894–1895, again with a SALT deduction included, federal income taxes were not levied again until the 16th Amendment gave the federal government the power to do it in 1913. This new income tax system contained more deductions than were in place in previous versions, also including a SALT deduction. Records of why this deduction was again included are scarce, but federalism arguments were used to support its inclusion.
Decades later, the over 50 subsequent tax laws passed by Congress have caused an evolution in the SALT deduction. The introduction of the standard deduction in 1944 limited its use to those who itemize their deductions, and in 1964 Congress limited the deduction to income, property, and sales taxes. In 1986, sales taxes were removed from the list of deductible items. The Alternative Minimum Tax (AMT) and the Pease limitations were introduced to limit the SALT tax deduction for higher income households. After the 1986 changes, however, tax policy analysts began to notice how the SALT deduction primarily benefited very high-income taxpayers in high tax states. Federalism arguments continued to be used to support this deduction, however, right up into the Tax Cuts and Jobs Act (TCJA) debate in 2017.
The caps on the SALT deduction that were put in place by TCJA were part of an overall reform effort to simplify individual taxation and reduce topline tax rates. The bill increased the standard deduction, allowing most previous users of the SALT deduction an overall higher deduction level even with the new caps. However, perceptions that this deduction cap was an attack on higher taxed Democratic states by a Republican president and Congress changed the tenor of the overall debate. Federalism and the regressive nature of the SALT deduction became arguments stuck in the back seat of the policy discussion. Though liberal leaning think tanks are pretty united in support of the cap, or even the total elimination, of the SALT deduction, Democrats and some Republicans coming from high tax states in Congress are still trying to find a way to get rid of these caps. Helping slow down this effort is the high price tag attached (over $1 trillion over 10 years).
Before these members of Congress succeed in providing a new tax cut for wealthy Americans in a few states, we should look once again at the original policy argument in support of the SALT deduction: federalism and the issue of “double taxation” of income by different levels of government. Double taxation occurs when the same income source is taxed twice by the same level of government, so clearly this is not what is occurring here. Each level of government provides a distinct set of services to its residents. These services come at a cost to that level of government, and they need to be paid for. As such, people are not being taxed twice on their income. They are simply paying for the different baskets of services being provided by each level of government. As noted by Brookings, “to call this double taxation is like complaining about paying for a burger from one store and paying for a muffin at a different one.” If this was even remotely the case, other countries with federal systems would have similar deductions, and they don’t. Moreover, residents tend to live in particular communities because they prefer the level and types of public services provided there.
Some argue that a portion of state and local government spending, like education and roads, provide spillover effects that benefit individuals in other states, thereby supporting the argument for the SALT deduction. Studies show that this cross-border benefit is relatively limited, however, and could be—and frequently is—subsidized more appropriately via federal grants and loans for specific projects and programs.
The federalism line of argument in support of the SALT deduction is similarly up for debate. While some members of Congress have noted concerns that the federal government could absorb a significant portion of taxable resources over time, to the detriment of state and local government, others have refuted this line of reasoning before the Constitution was even adopted. Federalists back then argued that Americans would “police the boundaries between state and federal authority by voting to preserve the separate spheres.”
There are many good reasons to oppose the state and local tax deduction. It is a relic from a previous period of high marginal tax rates, it encourages higher spending in high tax states, and it is really expensive. The biggest reason to avoid the SALT, however, is its heavy regressivity. According to a 1980s study by the Treasury Department, “the current deduction for state and local taxes disproportionately benefits high-income taxpayers residing in high-tax States. Although the deduction for State and local taxes thus benefits a small minority of US taxpayers, the cost of the deduction is borne by all taxpayers in the form of significantly higher marginal tax rates.”
Since there was never really a good reason for the federal government to create the SALT tax deduction in the first place, in our current era of relatively low marginal tax rates and a need to find ways to pay for key Trump Administration tax priorities, it would seem appropriate for Congress to try out a healthy, no SALT deduction diet. It does seem past time to make American tax policy healthy again.