Limits to SALT deductions would damage some state and local budgets

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LOS ANGELES — The hits to taxpayers from Republican tax reform proposals in high-tax states like California could result in diminished tax-raising ability or tax cuts that harm those states and their local governments’ ability to provide services, according to S&P Global analysts.

The GOP tax bill approved last week by the House Ways and Means Committee would eliminate the deduction for state and local income or sales taxes, and limit the property tax deduction to $10,000. The Senate GOP proposal announced last week would fully repeal the deductions. The plans would nearly double the standard deduction and eliminate other deductions, making itemization unnecessary for a larger percentage of tax filers.

There is still a question as to what ends up in a final tax bill because the Senate and House versions are substantially different and final versions aren’t expected until early December.

“California is probably Exhibit A among states most affected by the proposed changes,” said Gabriel Petek, an S&P Global Ratings analyst. “Taxpayers would see an increase in the overall tax burden if the state and local tax deduction goes away. It’s a triple whammy, because it’s a high income state, a high income-tax state and a state with high housing prices.”

Proposals to eliminate taxpayers’ ability to deduct state and local states when they file federal income tax and the $500,000 cap on mortgage interest deductions are particularly bad for high-tax states, because taxpayers in those states are more likely to take the SALT deduction and the median home values are above the cap, say credit analysts and government officials.

California, New York, New Jersey, Illinois, Texas, and Pennsylvania claim more than half of the value of the deduction, according to the Tax Foundation, a Washington D.C.-based think tank tank.

“If you look at the mid-Western states, doubling the standard deduction would represent a larger share of income there, because those states are lower property tax states,” Petek said.

SALT deductions for all states are worth about $100 billion in 2017, according to projections from the Joint Committee on Taxation.

Over 6 million California tax returns – one out of every three – claim SALT deductions, including millions of middle-income households that may not benefit from the increased standard deduction, wrote Michael Cohen, director of the California Department of Finance, in a letter to the California congressional delegation on Nov. 9.

Allowing up to a $10,000 deduction on property taxes provides some offset, Cohen wrote, but only one-fourth of the state and local tax deduction consists of property taxes paid. The average deduction for state and local income taxes alone is nearly $16,000 per return, he wrote.

Reducing the cap on the mortgage interest deduction to $500,000 will increase the cost of homeownership for many middle-class Californians, Cohen wrote. More than 4 million California tax returns claim the mortgage interest deduction at an average of over $12,000 per return.

New York City officials have estimated the value of SALT at $7 billion.

In states where taxpayers experience a heavier tax burden from the changes, it could make it hard for both those states and local governments to raise taxes and revenues, said S&P analysts Petek and Jane Ridley.

“What we said in our recent report about California having limited tax raising ability in a downturn would be accentuated,” Petek said. “What that implies is in the next downturn, or the next time the state has a budget imbalance, they would have to turn to making cuts to services instead of going back to taxpayers.”

S&P already viewed California as having limited tax raising ability, because the state has raised taxes and approved so many bond measures during the recovery.

“We are not saying it would immediately cause us to change our outlook or California’s rating, but it narrows the fiscal options in the future,” Petek said.

The states have a lot of legal autonomy over their fiscal structures, including the ability to raise taxes or cut spending, but there is also a practical side that includes politics, Petek said.

“At a certain point it is counterproductive to raise taxes,” he said. “There is not an agreed upon defined threshold where they have breached that limit, but I would have to think California is approaching that even at current rates, which reduces one of the state’s options. That is why this would put them in the situation of relying on the cutting side to balance the budget.”

It could also harm localities, because taxpayers would be less likely to support increases, Ridley said.

“You would definitely have some flow through to assessed value, if assessed value is going down, you have more people appealing those valuations,” she said. “Homeowners would also be less likely to trade up into more expensive homes with the cap at $500,000 to deduct mortgage interest.”

Currently only 29% of households in California can afford to buy a house with the median price of a home at $527,000 across the state, said Joel Singer, president and chief executive officer of the California Realtors Association.

Singer described the tax reform proposals as double-taxing Californians, which he said could affect many Californians' decisions to stay in the state. In addition, Singer said, it makes it difficult for the corporations that are already here to attract employees to California or keep them.

It’s a double tax, because “we are already in a state where many people, if not most homeowners, itemize,” Singer said. “Our research shows that depending on where Californians are in the state, they could be paying $3,000 to $6,000 more a year in taxes – depending on what size mortgage they have.”

New York Mayor Bill de Blasio also called the SALT and mortgage deduction cap a double tax at a Business Group Association for a Better New York breakfast on Nov. 6, the day before he was re-elected.

“This fundamentally undermines the lives of so many families,” De Blasio said. “It creates a reality of double taxation. And, I think this is a room of worldly, wise people, and you would agree with me something like state and local tax deductibility – it’s been a part of American life since 1913 – over a century.”

The deduction was included in the federal tax code when it was established in 1913.

“If that right — which was meant to give people opportunity and help them live a better life – if that is taken away; it will be gone forever, and it will undermine working families and middle class families,” De Blasio said.

Under the tax reform proposals, 760,000 of the 3.9 million families that file income taxes in New York City, the majority of whom make less than $75,000 annually, would see a tax increase averaging almost $5,000 next year, according to a City Hall fact sheet.

“That’s an additional $3.7 billion the federal government will claim from those New Yorkers,” according to the fact sheet.

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