SALT Cap Increase Has a Problem
The reconciliation bill currently being considered by Congress increases the SALT cap from $10,000 to $72,500. There is a problem, though: the current revenue estimate for the SALT cap increase may substantially underestimate revenue loss because states can easily change their law so as to allow taxpayers to take advantage of the larger cap by bunching their deductions into one year, and then not itemizing deductions the next year. This can be fixed by subjecting the SALT deduction to a floor of a specified percentage of AGI.
The Congressional Budget Office is currently working on a revenue estimate for the bill. If the estimate comes in with different numbers than what has been worked out so far, then adjustments need to be made in order for the bill to pass. If reports about what is in the reconciliation bill re SALT cap are correct, and it is a simple increase to $80,000, the revenue estimate needs to take account of possible state law response to this policy change, a response which could lead to substantial federal revenue loss that has not been included in the numbers so far.
The background is that the 2017 tax bill drastically reduced the number of taxpayers who itemize deductions, by increasing the standard deduction to $12,550 ($25,100 for married)(2021 levels). Further, the deduction for state and local taxes for itemizers is limited to $10,000. So to deduct state and local taxes you first have to itemize (the vast majority of taxpayers now don’t) and then you can deduct only $10,000.
Here is the problem: SALT is deductible only for itemizers. So for the vast majority of people (who do not itemize) increasing the federal SALT cap is not going to affect their taxes, UNLESS states make it easier for them. The substantial increase in the standard deduction in the 2017 tax law gives some people an incentive to itemize only every other year (or even every third year). For example, someone who normally does not have enough deductions to itemize can save up their charitable contributions and bunch them all in one year, and itemize in that year. Not that many people do that, however, for one thing because it mostly works for charitable deductions and most people don’t give large amounts to charity.
A similar bunching approach can be taken for the SALT deduction. Suppose that someone is paying $15,000 in state and local taxes, and currently is subject to the $10,000 cap so they can deduct only $10,000. This person might not even itemize, because their deductions are less than the standard deduction. If the SALT cap were raised, then this person could deduct $15,000 if they itemized. They can try to do even better and pre-pay some of their state tax this year, and then maybe not itemize next year. Maybe they pay $30,000 in state income tax. Then they get a bigger deduction. The problem is if someone did that then they would get a $15,000 state income tax refund in the following year for the tax overpaid, and that refund would be taxable (because it reflects a refund of a previously deducted item).
Here is where a State could respond. A state can change its law to provide that a person in the above situation who pays say $30,000 in state income tax and deducts it on their federal return thereby causes their state taxable income to increase. So by paying more state income tax, they will have correspondingly greater state taxable income, and hence no refund the following year because there is no overpayment. Here is the kicker: the state would also amend its law to allow a carryover loss in this situation: the amount by which state taxable income was increased by reason of the prepayment is allowed as a deduction in the following year, so that state taxable income is lower. In effect, the person prepaid their state income tax, gets a deduction for it, and then benefits by not having to pay as much (or any) state income tax the following year. They also take the standard deduction the next year, rather than the itemized deduction. The state could do the same for property tax: i.e. someone who prepays their property tax can get a reduced property tax liability the subsequent year.
With this approach, States can make it advantageous to itemize for large numbers of their citizens. No one’s state tax would go up, tho, unless they were doing this maneuver, so there is no downside to a state to doing this. The revenue estimate for the SALT cap increase should take this into account. This would make the SALT cap increase much more expensive than it is currently tentatively scored. It would also create a bit of a mess.
The Nov. 2, 2021, Yarmouth amendment to rules committee print 117–18 has the following anti-avoidance language: “…the Secretary shall prescribe regulations or other guidance which treat all or a portion of such taxes as paid in a taxable year or years other than the taxable year in which actually paid as necessary or there appropriate to prevent the avoidance of the limitations of this paragraph.” (The Nov. 18 manager’s amendment does not change this language.) While regulations might address the State law response outlined here, the above language does not authorize them. The problem is that it authorizes regulations only “to prevent avoidance of the limitations of this paragraph”. The state law response that I identified above does not involve avoiding the limitations of paragraph 6. Rather, it involves allowing taxpayers to take advantage of the standard deduction rules, which are contained in a different code section. It is not even clear that what is involved could be considered “avoiding” the limitations of the standard deduction rules, but in any case it is clear that the limitation of section 164(b)(6) is not being avoided. No taxpayer would be deducting more than the limit; it is just that they would be itemizing in some years rather than others.The language authorizing regulations seems to be directed at a different problem, namely for some of the ;ater years where the SALT limitation is scheduled to revert to $10,000. In this case, the taxpayer might try to accelerate the payment of taxes into a year where the limitation is higher. This maneuver would be trying to avoid the limitation of paragraph 6, and regulations could deal with this. But the authorization for regulations is not broad enough to cover the types of state law responses that I described above, since they do not involve avoiding the limitation of paragraph 6.
What is the fix? One approach would be to revise the above language about regulations and authorize them also for the purpose of avoiding misuse of the standard deduction rules. My preferred fix would be to include a floor on the SALT deduction. In the past I have suggested 5 percent of AGI, but it could be higher or lower than this, there is no magic number (except you don’t want it so high that virtually no one can benefit from the deduction). Combined with the floor, everyone would be allowed to take the SALT deduction, regardless of whether they itemize generally. My earlier proposal was to get rid of the concept of itemized deductions altogether and subject each deduction to an AGI floor — for charitable, it might be 2 percent of AGI for example. On the reconciliation bill, Congress might not be ready to adopt my entire proposal, but at least it should institute an AGI floor for SALT and allow more people to deduct SALT even if they do not itemize. To avoid revenue loss, there could be a rule that only if you deduct more than the current 10K cap would you become subject to the floor (but also you should then be allowed the deduction even if you otherwise do not itemize).
Here is one possible structure for the rule: A special deduction for SALT would be allowed, regardless of whether the taxpayer itemizes deductions or not. The amount of the deduction would be the amount of state and local taxes paid, reduced by the sum of —
(a) $10,000, and
(b) 5 percent of the taxpayer’s adjusted gross income (7 percent in the case of the portion of adjusted gross income in excess of $250,000).
Under this rule, someone paying $10,000 or less in SALT will not be able to benefit from this deduction: they will be able to deduct their SALT paid only if they itemize. Those seeking the benefit of this deduction would first have to subtract $10,000, regardless of whether they deduct this amount as an itemized deduction or not, and in addition would have to subtract 5% of AGI (7 percent for AGI in excess of $250,000). There is no limit on the deduction, but because the floor is progressive, the amount deductible by the wealthy is reduced.
I don’t know what the revenue impact of this rule would be, but it may well be less than what is in the reconciliation bill currently. Another option to reduce revenue loss (and increase progressivity) further would be to include an additional floor — perhaps 10% of AGI for AGI over let’s say $400,000).
