President Trump’s plan to overhaul the federal tax code threatens to fall disproportionately on residents of liberal-leaning states, a short-term boost for state governments that could turn into a long-term drag.
Most states have tied their tax codes closely to the federal code. Since the federal income tax was first levied in 1913, taxpayers have been able to deduct the state and local taxes they pay from their federal taxable income. Taxpayers who live in states with higher tax rates are able to deduct more from their federal taxes than those who live in states with lower rates
Those deductions cost the federal government more than $60 billion a year, according to the nonpartisan Tax Policy Center.
Trump has proposed ending that state and local tax deduction. Experts who reviewed Trump’s outline, issued Wednesday, said that will mean higher taxes for those who live in states with more progressive tax codes, like California, New York, Oregon and New Jersey.
“Individuals, particularly in high-tax states, would see their state tax burdens increase. The federal government is essentially subsidizing high tax rates in states like California and New York,” said Nicole Kaeding, an economist at the Center for State Tax Policy. “Those taxpayers would be impacted pretty directly by the Trump tax plans.”
In the short run, eliminating the deduction would mean taxpayers would have to report a higher income — meaning state tax bases would grow, at least a little bit. That could make a difference for policymakers in states where tough financial times have meant penny-pinching during budget negotiations.
In Oregon, lawmakers are trying to close a billion-dollar budget hole as revenues fall short of projection. New Jersey lawmakers grappled with their own billion-dollar shortfall last year. And in his initial projections, California Gov. Jerry Brown (D) said his state would have to cut costs to avoid a $2 billion deficit this year.
“The states that have higher progressive taxes and higher income residents who benefit from deductibility tend to be blue states,” said Iris Lav, a senior fellow at the left-leaning Center on Budget and Policy Priorities.
“This discount is pretty important, especially for states that want to have a somewhat higher and more progressive income tax.”
History suggests states are likely to react to the Trump tax cuts, if they make it through Congress. The last time Washington overhauled the federal tax code, in 1986, Congress eliminated a general sales tax deduction, and several states cut their taxes to come into line with the new federal code.
Other states made changes, too, in ways that allowed them to capture some additional revenue. States like Minnesota and New York dramatically reduced the number of tax brackets they levied on their own citizens.
“Likely, what you would see is that states would make some changes” to their tax code after the federal plan is passed, Kaeding said. But states would be unlikely to make those changes this year, given that many budgets are already written ahead of the start of the new fiscal year in July.
Ending state and local tax deductions would have a significant impact on taxpayers who itemize their taxes. More than 45 percent of those earning between $50,000 and $100,000 a year itemized their taxes, according to the IRS and the Tax Foundation.
More than 80 percent of those earning over $100,000 did so, and the state and local tax deduction cut their adjusted gross income by more than 6.5 percent.
Other elements of Trump’s tax plan present a more immediate threat to state budgets: Fourteen states and the District of Columbia levy a tax on wealthy estates, and all but one of those states depends on the federal estate tax to do so. Trump has proposed eliminating the estate tax, which could cost those states $3 billion in annual revenue.
And states are closely watching how Congress and the Trump administration handle pass-through businesses. The current proposals would allow some businesses to pay lower rates on their profits, which could further reduce a state’s tax base.
The short-term boost in tax revenue could help mitigate some of those budget gaps, at least at the margins. But coupled with deep cuts the Trump administration has proposed for social programs and health care, that boost could be little more than a band-aid on a deeper cut.
“We have budget shortfalls coming up in at least half the states,” said Lav, of the Center on Budget and Policy Priorities. “They’re very worried about the cuts in programs and health care and so forth.”