Connecticut weighs a far-reaching tax swap in response to SALT cap

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Gov. Ned Lamont and top Connecticut lawmakers are studying a proposal to essentially swap much of the state’s income tax for a payroll tax.

The radical move — too late for serious consideration in this legislative session, scheduled to end next Wednesday — has triggered widespread discussion about how the change in Connecticut’s tax structure could affect its residents, and its standing in the capital markets.

Essentially, a 5% payroll tax, plus an additional 2% tax on annual income above $200,000, would replace the graduated state income tax. The state’s earned income tax credit would rise to offset the higher tax liability for low-income earners.

Backers tout the proposal as an end run around the federal government’s 2017 Tax Cuts and Jobs Act, notably its $10,000 limit on the personal income tax deduction for state and local taxes paid, known commonly as SALT. The payroll tax would be fully deductible, because all taxes businesses pay the federal government are fully deductible when calculating their federal tax liability, according to the Connecticut School Finance Project, which is behind the proposal.

“It’s an intriguing idea, but also a potentially very complex one,” Jared Wolczak, a senior analyst with the Washington-based Tax Foundation, wrote in a post for the foundation.

The federal law has hurt Connecticut taxpayers, the Connecticut School Finance Project says.

The New Haven-based nonprofit, citing the state Department of Revenue Services, said roughly 170,000 Connecticut taxpayers stand to lose a combined $10.3 billion in state and local tax deductions, resulting in an increased federal income tax liability of $2.8 billion.

“I think that considering the circumstances there are many state and local governments who are at the point where they need to try anything that happens to be inside, or even outside of the box,” said Tom Kozlik, a director and the head of municipal strategy and credit at Hilltop Securities.

Obstacles, ranging from federal government buy-in to stress testing, would be steep.

“There are performance threats here for Connecticut municipal bonds as an asset class, but a change of this type has the possibility of aiding economic growth while helping to close out-year state budget deficits,” said Municipal Market Analytics.

“More importantly for municipal investors, the Connecticut proposal is symptomatic of state and local governments continuing to re-optimize their tax and spending regimes following [the SALT limitations].”

Such a change would be a heavy lift for Connecticut, said Alan Schankel, a managing director at Janney Capital Markets.

“It seems to me they have a lot of challenges ahead,” Schankel said. “If their primary goal is to get around SALT, which it seems like it is, it’s a little difficult to make that argument.”

Both Schankel and Kozlik cited the political fluidity of the SALT deduction.

“Once a state is able to set a circumvention strategy up that may be technically or legally sufficient, it is possible those circumstances could change or be taken away,” Kozlik added,

Connecticut’s recent history of fiscal strife — budgetary imbalance, high debt and legacy costs, and bond-rating agency backlash until this year — provide a backdrop.

S&P Global Ratings’ revision in March to positive from stable on its A rating marked the first upward rating agency tweak to Connecticut's general obligation bonds since 2001.

The state received across-the-board downgrades in 2017. Moody’s Investors Service rates Connecticut GOs A1, while Fitch Ratings rates them A-plus. Kroll Bond Ratings Agency assigns its AA-minus rating. Kroll assigns a negative outlook, while outlooks from Moody's and Fitch are stable.

Connecticut’s secondary market spread to the AAA Municipal Market Data benchmark has fallen by about 30 basis points over the last two months to just over 50, according to Refinitiv data.

“The narrowing spread is more due to technical market dynamics, not necessarily because of credit-related improvements,” Kozlik said.

“From a credit perspective, Connecticut has on the one hand high income levels and its budget reserve or rainy day fund balance is trending in the right direction. On the other hand the state’s fixed costs, including unfunded pension liabilities, are among the highest in the nation, its economy is lagging the rest of the country and demographic trends are not moving on a positive course.”

Also, said Kozlik, Connecticut’s vast shoreline warrants scrutiny, given climate-change risks.

“Connecticut is not completely out of the woods yet,” said Glen Anderson, a senior vice president with Nuveen Asset Management. “But we must acknowledge the advances made this year.”

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Income taxes State taxes Payroll taxes State budgets Tax laws Ned Lamont State of Connecticut Connecticut