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.”