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Financial Planning > Tax Planning > Tax Deductions

State Tax Workarounds Could Punch $154 Billion Hole in Federal Budget

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New York state lawmakers could punch a $50.6 billion hole in the federal government’s budget by revamping their state income tax.

If California followed the same approach, its legislature could keep $66.8 billion out of the U.S. Treasury. And in New Jersey, state lawmakers could hold back $12.5 billion more.

(Related: IRS Releases Tax Withholding Tables for 2018)

Their plans face obstacles, and not every state is pursuing the same strategy. But five Democratic-leaning states that are exploring ways to change their tax laws could remove roughly $154 billion from federal coffers over the next eight years, adding to anticipated deficits, according to an analysis compiled by Bloomberg in conjunction with Daniel Hemel, a professor at the University of Chicago Law School.

The potential drop in federal revenue reflects a furious burst of creativity among state lawmakers and tax experts in response to the Republican-sponsored federal tax-overhaul legislation that President Donald Trump signed last month. One controversial piece of the new law caps a previously unlimited federal tax benefit that individuals in high-tax states get by deducting the state and local taxes they pay. The new cap is $10,000.

Now, various states are considering circumventing that limit by switching from a state personal income tax to an employer-paid state payroll tax calibrated to produce the same amount of revenue. Employers can deduct payroll taxes fully on their federal returns.

To see what that kind of change could mean for federal revenues, Hemel created a formula to apply to state data. The resulting $154 billion total included $16.8 billion for Illinois and $7.5 billion for Connecticut.

Spokesmen for the White House and for Congress’s main tax-writing committees didn’t respond to requests for comment on the analysis.

Talk of a payroll tax maneuver is loudest now in New York. On Jan. 17, the state’s Department of Taxation and Finance released a preliminary report outlining its options for tax changes. The report includes analysis of workarounds such as “a statewide employer compensation expense tax,” or payroll tax. New York state budget director Robert Mujica says lawmakers will have draft legislation to debate within 30 days.

“What we are trying to accomplish here is to put [New Yorkers] back to where they were” before the new tax law, said Mujica. “The federal tax law aimed at the heart of New York and California, and we produce 25% of GDP for the nation.”

It’s not clear how much revenue federal tax writers gained by capping the so-called SALT deduction at $10,000. An estimate by Congress’s Joint Committee on Taxation combined that tax change with other cutbacks to various deductions and said the entire package would generate $668.4 billion in new revenue through 2026, when the changes in the new law are set to expire.

“Presumably, the capping of the SALT deduction program represents the lion’s share” of that revenue boost, according to several law professors and other experts who wrote about the changes in a Dec. 13 paper, “The Games They Will Play.” The paper anticipated the kinds of economic war games that New York and other states are contemplating.

If states’ shifting to payroll taxes becomes a “large enough trend, [it] could wipe out all the savings from the repeal of the SALT deduction — and then some,” wrote the authors.

That’s because most federal taxpayers don’t itemize their deductions — meaning they don’t benefit from the SALT write-off for state income taxes. But all employers could deduct payroll taxes as expenses, the paper notes, making “a sizable portion of all current state income taxes deductible.”

The paper notes that “states already impose a payroll tax for unemployment insurance purposes, and many localities impose an additional payroll tax as well — and employers currently can claim a deduction for their portion of those taxes.”

But that doesn’t mean that making the switch to payroll taxes would be easy for states. Complications include how to adapt state income tax systems with progressive rates — like the federal tax brackets; how to handle workers in the gig economy with multiple employers; how to address employees who live in one state but work in another; and how to tax non-wage income, such as from investments.

Also, the Internal Revenue Service might not approve of the approach, according to a Jan. 5 report by Jared Walczak, a senior policy fellow at the conservative-leaning Tax Foundation, a Washington policy group. An employer-side payroll tax, paired with a full tax credit, could be seen by the IRS “to constitute payment of an employee’s income taxes by the employer, which would not only negate the benefit of the plan but could actually increase taxpayer liability,” Walczak wrote.

Sinatra’s Line

Hemel said he thinks New York can work through the challenges presented by its progressive state income tax and its many commuters from other states, showing the way for other states with flatter tax systems and fewer cross-border commuters. “Frank Sinatra’s line applies well here: If this can make it there, it can make it anywhere,” he said.

The payroll tax option has “a lot of sticking points, but conceptually it’s a workable scheme,” said Frank Sammartino, a senior fellow at the Tax Policy Center, another Washington policy group.

New Jersey is also looking into the feasibility of a payroll tax, said Representative Josh Gottheimer, a New Jersey Democrat. But he said the potential complications have him more bullish on another idea: letting taxpayers make charitable donations to a state fund that supports public services like education or health care rather than pay that amount in state income tax. Residents would get a state tax credit for the contributions, which they could deduct on their federal returns as charitable donations — if they itemize deductions.

California’s Considerations

California is pursuing the same approach — in part because procedural issues there make a payroll tax approach more burdensome, said Kirk Stark, a UCLA Law School professor of tax law and policy. Any tax increase — including to payroll taxes — would require a two-thirds approval in both the state Senate and Assembly, and reducing income tax rates in California would require a constitutional amendment, he said. Still, Stark said, it wouldn’t be impossible.

The charity approach almost certainly wouldn’t have as much effect on projected federal revenue as the payroll-tax approach would. That’s because of another change in federal tax law — a near doubling of the standard deduction that’s expected to result in fewer taxpayers itemizing their deductions. A new standard deduction worth $24,000 per married couple would outstrip the average SALT deduction claimed in all states, according to 2015 data. (The highest average was in New York, $22,200.) Experts estimate that about 90% of individual taxpayers will take the standard deduction going forward.

Estimates’ Methodology

Hemel’s analysis of the payroll-tax plan relies on statewide wage income figures, an average state income tax rate, an average marginal federal tax rate, and an assumption for the percentage share of state income taxes that won’t be deductible under the new tax law.

Since taxpayers who don’t itemize don’t report state income taxes to the IRS, Hemel approximated the average state income tax rate by dividing individual income tax collections by individual income. He used the middle federal tax bracket of 24% and placed the share of state income taxes that will not be deductible under the new law at 90%, since about 90% of individuals will claim the new, higher standard deduction, and many itemizers will hit the new $10,000 SALT cap based on property taxes alone. 

In New York’s case, state wage income for 2015 was $516.8 billion. Hemel calculated an average state income tax rate of 4.76%, then applied a 24% federal rate. Factor in the 90% share of state income taxes that Hemel figures wouldn’t be deductible under the tax law and the total is $5.3 billion. 

The calculations then factored in a nominal wage growth measure — the index of aggregate weekly payrolls — which rose 9% from June 2015 to June 2017. A conservative nominal wage inflater of 2.5% a year was then applied to subsequent years.

Hemel’s method “looks reasonable to me, and clever,” said New York University law professor David Kamin.

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