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Americans like their tax deductions, but mainly because the tax rate to begin with is too high. This same principle holds for the state and local tax (SALT) deduction currently part of the 74,000+ page federal tax code. This deduction seems like a good idea, but Americans would be much better off with this deduction eliminated, and instead given real tax breaks across the board. Fortunately, the GOP tax reform framework released at the beginning of the month does just this.
The SALT deduction allows taxpayers to deduct the amount that they pay in state and local taxes from their taxable income for federal tax purposes, so that they do not pay tax to the federal government on income that they do not spend or save. This sounds great, and sounds like lower taxes. However, in reality, its consequences outweigh its benefits. Tax reform should, and the tax reform framework does, eliminate the SALT deduction in favor of instead slashing federal income tax rates across the board.
To understand the harm done by the SALT deduction, it is necessary to understand what the utilization of the SALT deduction does to state and local tax policy. The more taxpayers choose this option, the more states and localities are inclined to raise their own taxes, as those who pay more in state and local taxes receive a larger benefit from choosing to utilize the SALT deduction. This is because when an individual pays a larger sum in state taxes, he or she, by utilizing the SALT deduction, may report a lower taxable income to the federal government.
This effectively lowers the net cost of state and local taxes. The resultant transferring of a portion of the tax burden from the residents of a state to the federal government is encouragement for states to raise taxes, eliminating the benefit of the deduction in the first place.
This takes us to the regressive nature of the SALT deduction. By giving a tax break on federal income taxes, individuals with higher income rates are more likely to utilize the SALT deduction, and therefore more likely to benefit from it. Multiple studies have confirmed this. The Tax Policy Center of the Urban Institute and Brookings Institute found in a study that of the 30 percent of tax filers that claimed the SALT deduction in 2013, 11 percent had incomes under $50,000, while 82 percent had incomes over $100,000.
Getting at the benefit to higher-income individuals, then, a study by the Tax Foundation found that 88 percent of the resulting benefit from the SALT deduction flowed to those taxpayers with incomes above $100,000 and only 1 percent to taxpayers with incomes below $50,000. This disparity is staggering, but not surprising. Lower-income earners should be considered in reforming federal tax policy, and eliminating the SALT deduction does just this.
In order to benefit all taxpayers, federal tax policy should instead encourage tax cuts in all areas. By entirely cutting the SALT deduction out of the federal tax code, pressure would be put on states and localities to lower taxes, because the net cost of their taxes to taxpayers would no longer be reduced by the federal government. The GOP tax framework eliminates the SALT deduction and instead provides income tax relief to all taxpayers, not just higher-income taxpayers, by increasing the standard tax deduction and cutting the current seven-bracket structure to a three-bracket structure with lower rates.
Real tax rate reductions, not itemized deductions that arbitrarily benefit some taxpayers over others and create negative runoff effects in state and local tax policy, are the key to boosting the American economy and generating prosperity for Americans of all income levels. The tradeoff of the SALT deduction for such real tax cuts laid out in the GOP tax framework would allow Americans to keep more of their money by reducing taxes at all levels of government, therefore boosting business investments and job growth, and spurring economic growth nationwide.