D.C. Republicans’ big tax overhaul hinges on killing one of Minnesota’s favorite deductions

The Republican Party’s message on their plan to overhaul the U.S. tax code has been straightforward: they are aiming to make taxes lower and simpler to file.

Last week, GOP leaders released a long-awaited “framework” illustrating how they would accomplish that goal. It’s the clearest statement yet of the party’s priorities as it attempts to make the biggest changes to the tax code in 30 years; much of what’s in it is likely to appear in whatever legislation they introduce in the coming weeks.

As Republicans make the case for their plan, there has been scarcely any talk of whose taxes might go up as a result of the plan. But one important element of the tax framework, if enacted, could increase tax bills significantly for some U.S. taxpayers.

The GOP plan proposes eliminating the state and local tax deduction, or SALT deduction, which lets tax filers deduct the taxes they pay to state and local governments from their total taxable income. For people who live in places with high income or property taxes, it’s a deduction that can save thousands of dollars a year, and it’s one of the most popular deductions in the entire U.S. tax code.

The SALT deduction has long been in the GOP’s crosshairs: they say eliminating it would only affect a small group of people — primarily in high-tax blue states, no less — while helping pay for significant tax cuts elsewhere. To hear others tell it, the SALT deduction saves families money and boosts the ability of state and local governments to provide services.

Minnesota is well above-average in the number of residents who claim some SALT deduction — roughly a third of tax filers in Minnesota do. The policy’s importance in the North Star State is fomenting interesting politics in Washington, with Minnesota Democrats generally in favor keeping a tax break primarily claimed by wealthy filers; Republicans, under pressure to back their party’s tax initiative, have been harder to pin down on the fate of the SALT deduction.

Deductive reasoning

The SALT deduction is as old as the federal income tax itself — it became law in 1913. Currently, it primarily protects people from getting hit hard with tax bills from federal, state, and local governments by letting filers deduct their state and local taxes from their total income that gets taxed by Uncle Sam.

When the deduction was implemented, however, it had a different intention, according to V.V. Chari, a professor of economics at the University of Minnesota. He explains that the ability of taxpayers to deduct state and local taxes from their income effectively served as a subsidy from D.C. to local governments: with residents feeling less of a squeeze from local taxes, jurisdictions felt freer to raise rates, increasing their budgets for goods and services.

“That was the original rationale,” Chari says, “that it would be effectively a transfer to the states, for a variety of local goods, principally education, but a variety of local and state-provided goods.”

That function is still important to state and local governments, Chari says, even if they receive federal assistance in different ways now. He uses the example of a Minnesotan making $1,000,000 — subject to a 9.85 percent state income tax rate and a 39.6 percent federal income tax rate — to illustrate the point.

Deducting that person’s $100,000 tax liability to the state of Minnesota, Chari explains, means their federal taxable income drops to $900,000.

“What that means is your federal tax liability is $40,000 less than it would have been if your state and local taxes were not deducted,” he said. “It’s as if the federal government is paying $40,000 to the state of Minnesota on your behalf.”

According to a report from the Tax Policy Center, a nonpartisan tax research think tank, “Federal tax subsidies through the SALT deduction and the federal tax exemption for state and local bond interest provided an additional $135 billion in implicit federal support for state and local governments.”

On the household level, the SALT deduction primarily benefits high earners who live in jurisdictions with high taxes, per the Tax Policy Center.

Among filers making over $100,000, 81 percent claimed the SALT deduction, while around 10 percent of filers making less than $50,000 did. The deduction applies to a broad range of state and local taxes, but income and property taxes account for 95 percent of the state and local taxes deducted.

The SALT deduction is one of the biggest tax breaks available, and it’s among the most popular: about 40 million taxpayers claim it every year. No surprise, then, that it’s among the most expensive to the federal government: it cost nearly $100 billion in 2016, and if it remains in place, it is expected to cost $1.3 trillion over the coming decade.

Minnesota is among the top third of states in percentage of people who claim the SALT deduction, a group led by Maryland, New Jersey, and Connecticut, states where over 40 percent of filers claim it.

The 32 percent of Minnesota tax filers who claim it deduct an average of $11,600. Fully half of Hennepin County households claim it, netting an average deduction of $17,600, according to the National Association of Counties.

Across the border in South Dakota — where there is no state income tax — the story is very different. Only 17 percent of filers claim the SALT deduction, and get an average deduction of $5,800.

Within Minnesota, the importance of the deduction depends on where you are. In the 3rd Congressional District, encompassing the affluent west metro suburbs, 46 percent of filers claimed an average deduction of $8,000, per a Bloomberg analysis. In the rural 7th Congressional District, however, only 25 percent of filers claimed an average deduction of $2,500.

A ‘non-starter’ for Democrats

If Congress eliminates the SALT deduction, the 32 percent of Minnesota tax filers who claimed the deduction would see an average increase of $2,261 in their federal tax bill, according to the Tax Policy Center.

Even the perception of a tax hike is anathema to most Republicans. But they are defending the elimination of the deduction by making two key points: that other tax cuts and tweaks elsewhere will mitigate the pain, and that the revenue generated by ending the SALT deduction is necessary to help pay for the broader tax overhaul.

Second District GOP Rep. Jason Lewis said in a statement that the tax framework’s proposal to double the so-called standard deduction, which would protect the first $24,000 of a filer’s income from taxation, would prompt fewer people to claim the SALT deduction.

“That saves you time and money preparing your returns, thus providing significant tax relief for families in the 2nd District,” he said. (Forty-two percent of Lewis’ constituents claim the SALT deduction, per Internal Revenue Service data.)

But GOP policymakers, making deep cuts elsewhere in the tax code, are desperate for some sources of revenue as they try to make the case to the public that their plan is neutral on the federal deficit.

The roughly $1.3 trillion that would be raised by ending the SALT deduction would help pay for the big tax cuts the GOP is proposing elsewhere. Chari estimates that savings could pay for 15 to 25 percent of the entire tax plan.

“If they do away with [eliminating the deduction], an important source of revenue will disappear, and the ability to reduce other taxes will be severely constrained.”

Chari cautions that it’s difficult to consider the SALT deduction in a vacuum, because it exists within the larger framework of a sweeping tax plan. “Once you start pulling on one string, the whole package might unravel,” he said.

On its own, however, getting rid of the deduction might prompt state and local governments to reduce their tax rates, Chari said.

“I think [the SALT deduction] is an inefficient way to provide to schools, and the cops, and there are more efficient ways of getting there,” he explained. “All this does is create incentive for politicians in state and local governments to free ride off everyone else and raise taxes more than they might otherwise.”

Groups that represent state and local governments are not buying that line of argument, and they have mobilized furiously against getting rid of the deduction.

The National Association of Counties, in fact sheets that have circulated on Capitol Hill, called the plan a “$1.3 trillion revenue grab by the federal government,” and argues that the SALT deduction “supports local school funding, home ownership, lower middle-income taxes, tailored social services, infrastructure development and local job creation efforts.”

The U.S. Conference of Mayors sent a letter to Congress this week urging members to oppose ending the SALT deduction, saying it supports “vital investments” in infrastructure, public safety, and education. The mayors of Burnsville, Rochester, Brooklyn Center, and Eden Prairie signed on to that letter.

The National Association of Realtors claims that losing the ability to deduct local property taxes, which accounts for 35 percent of SALT deductions, would discourage home ownership and lead to a 10 percent decline in property values.

First District DFL Rep. Tim Walz agreed that the deduction is important to local governments. “The GOP proposal to end the state and local tax deduction would hamper the ability of our local governments to provide essential services, such as public education, and would likely result in a tax increase for the middle class,” he said in a statement. “It is a non-starter for me.”

Scrambling politics

The nature of the SALT deduction is scrambling the typical, party-line character of tax debates in Washington. Democrats are largely arguing in favor of tax break that tends to benefit wealthier people, while Republicans are advocating for what is, on its face, a tax hike for affluent property owners, many of whom vote Republican.

Analysts have pointed out the irony that this proposal would hurt blue-state Republicans the most. Of the 20 congressional districts where the most people claim the SALT deduction, nine are held by Republicans. (One of them is the Minnesota 3rd.)

Republicans representing affluent districts in high-tax states have begun lobbying their colleagues and the administration to save the SALT deduction. Rep. Peter Roskam, a Republican who represents an affluent district in the suburbs of Chicago, said the issue “has to be dealt with” and that members from high-tax states “have to be accommodated.”

Though the revenue gained by eliminating the deduction would provide critical support to the GOP tax plan, the White House has signalled that preserving it is not totally off the table; top economic adviser Gary Cohn said it is “not a red line.”

While Rep. Lewis is in favor of getting rid of the deduction, Reps. Erik Paulsen and Tom Emmer were far more non-committal. (Paulsen is a member of the Ways and Means Committee, the tax-writing panel with enormous influence over this process.)

In statements provided to MinnPost, neither Republican specifically mentioned the SALT deduction, and both emphasized that the GOP’s nine-page tax framework is simply a starting point.

“The Republican unified tax reform framework is just that — a framework,” Emmer said. “I am encouraged with our jumping-off point.”

“We will be working to fill in additional details, and no final decisions have been made,” said Paulsen. “But tax reform is about helping families keep more of their hard-earned money and boosting paychecks.”