Capitol Alert

California can preserve state and local tax deduction, even if Congress ends it

If Republicans’ tax overhaul passes next week, California taxpayers are likely to lose many of the state and local deductions that saved them more than $100 billion on their taxes in 2015. But legislative staffers and tax law experts are already gaming out ways to adjust the state’s tax code to offset the loss of those deductions and counter other changes to federal taxes.

That could save Californians a lot of money – but also explode the federal deficit.

State lawmakers have not yet put a specific proposal on the table. They don't want to get ahead of unfinished federal policy. But one senior California Assembly aide said it wasn’t a matter of whether state leaders adjust tax laws, but how and how much.

And those legislative maneuvers are likely to have a lot more success protecting California taxpayers than lawsuits. Gov. Jerry Brown and two of his fellow blue state counterparts, Gov. Andrew Cuomo of New York and Gov.-elect Phil Murphy of New Jersey, raised the specter of legal challenges to the tax overhaul on a conference call with reporters earlier this week.

“I’m not a lawyer but I’m betting there are some holes and flaws in this,” Murphy said. “We’re going to have to take this to the limit.”

Tax law experts, however, are dubious. “Any constitutional challenge to the rollback of the state and local tax deduction would face an uphill battle,” University of Chicago Assistant Professor of Law Daniel Hemel said via e-mail. “The 16th Amendment gives Congress the power to tax income from whatever source derived, and the Supreme Court has said repeatedly that deductions are a matter of legislative grace.”

Hemel and other academics say there are far more promising ways for states like California and New York to counteract the rollback of the state and local tax deduction that congressional Republicans are on the verge of enacting.

Under current law, taxpayers who itemize their deductions can write off the state and local taxes they pay. California is one of six high-cost, high-tax states that together claimed more than half of all state and local tax deduction dollars in 2014, according to the Tax Foundation, a center-right think tank in D.C. The others are New York, New Jersey, Illinois, Texas and Pennsylvania. Californians save more on their taxes from the deduction than people from any other state.

As it stands now, both the Senate and House versions of the tax overhaul would eliminate deductions for state and local income and sales taxes, while keeping the deduction for the first $10,000 of property taxes. Republicans in Congress are trying to hammer out differences between the two bills, with the goal to vote on final passage by Dec. 18.

Nothing is guaranteed in today’s political environment, but GOP leaders are optimistic that they will be able to round of the votes they need to get the bill enacted into law.

If that happens, the easiest workaround for states like New York and New Jersey would be to lower income taxes and raise property taxes, up to the point that residents can still deduct them.

California doesn’t have that option. Its Proposition 13 restricts property taxes to 1 percent of the property’s value, so any change to property taxes would need to go on the ballot for a vote.

But California could shift its tax burden away from income tax — one of the highest in the nation —and onto employers via the state payroll tax. Unlike individual taxpayers, employers would still be able to deduct this state tax on their federal returns.

A group of tax law experts that includes Hemel and University of California, Davis Law Professor Darien Shanske write in a paper published Dec. 7 that such a tax “would function, in economic terms, very similarly to an income tax imposed directly on the employee.”

Other options outlined in the paper include making it easier for taxpayers to make charitable contributions to state and local governments. Congressional Republicans plan to maintain the existing write off for donations to charity, which means Californians could deduct those contributions from their federal taxes.

And the state could provide tax credits in the amount of the donation, which taxpayers could use to lower their state income tax liability, as well. As University of California Hastings College of the Law Associate Professor Manoj Viswanathan observes in another recent analysis, “Many more taxpayers could take advantage of state-level initiatives that essentially reclassify state and local tax payments as federal charitable contributions,” essentially allowing them to “double dip” and obtain both state and federal tax benefits from a single donation.

Hemel, Shanske, Viswanathan and the Dec. 7 paper’s other authors believe states like California, which disproportionately benefit from the state and local tax deduction, are likely to make these or other changes to their tax code if the Republican proposal becomes law. The Assembly aide agrees, suggesting one obvious target would be the main beneficiaries of Congress’ tax plan —corporations, business owners, investors and the very wealthy. That runs counter to the argument, made by some conservatives, that ending state and local deductions will force high-tax states to lower their taxes, across the board.

It could also create major budget headaches for the federal government down the line. As it stands now, Congress’ nonpartisan Joint Committee for Taxation has estimated the Republican tax overhaul could cost the government $1 trillion in lost revenue over a decade. If states figure out ways to effectively preserve the state and local tax deduction, those costs could balloon even further.

According to Nicole Kaeding, a Tax Foundation economist, the state and local deduction will cost the federal government $1.8 trillion over a decade. If Republicans’ tax legislation fails to truly end the deduction, the federal government could bring in far less money in the future, pushing the deficit from the billions to trillions.

Emily Cadei: 202-383-6153, @emilycadei

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