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In Wake Of Federal Tax Reform, Blue States Scramble To Hide High Taxes

By Kyle Samminthe Federalist

Since the Tax Cuts and Jobs Act became law in 2017, government officials in high-tax states have been frantically trying to find a way to overturn the provision that limits taxpayers’ deduction for state and local taxes to $10,000. That limit makes taxpayers in high-tax jurisdictions feel the impact of their local governments’ tax-and-spend policies more keenly, and those governments will do anything (short of actually cutting taxes) to prevent that from happening.

First they resorted to weird workarounds that will surely be ignored by the Internal Revenue Service and struck down by the courts as the ruses that they are. Then they sued in federal court to stop Congress from changing the tax law. The lawsuit is without merit—it’s so bad, even California declined to join it.

Now at least one state, Connecticut, is considering radically reordering its tax system in a way that will be objectively worse for its citizens, all to spite the federal government. Sooner or later, these tricks will be used up and the high-taxing states will have to face reality.

Like It Or Not, The Government Can Tax All Income

Any analysis of the federal income-taxing power must begin with the Sixteenth Amendment to the Constitution, which is brief but sweeping: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.” While Article I always gave Congress the power to impose direct taxes, the Sixteenth Amendment removed the constitutional restrictions on that power that made its exercise practically impossible.

That power, with the pre-1916 restrictions removed, is as broad as it gets. If you have income, the federal government can tax it. From the beginning, courts have recognized the sweeping nature of the Sixteenth Amendment and, in 1955, clarified further just how broad the amendment is in the landmark case of Commissioner v. Glenshaw Glass Co. In that case, the upheld the Internal Revenue Code’s definition of income as being truly “all-inclusive.”

To admit this does not require an endorsement of high taxes, or indeed of any taxes at all. To say that the government can tax all income does not mean you think they shouldtax all income. It is only to admit a fact that, until recently, Democrats were especially fond of acknowledging: the government has the power to tax your income.

Admitting that also does not mean that the government must tax all income. We have never had a truly flat tax. The 1916 Revenue Act, for example, allowed a deduction for foreign taxes as well as state and local taxes (commonly abbreviated as SALT). It also contained deductions for depreciation, depletion, and interest that are similar to those still in the code.

But none of these deductions were a matter of right; they were legislative choices, undertaken to reduce the burden of taxation in ways that Congress thought made the income tax fairer. That’s a fine idea, but it does not create an inalienable right to that tax deduction.

State-Level Tax Evasion

Connecticut’s plan to beat the system is clever—too clever, really. Jared Walczak of the Tax Foundation explained the details in a recent article: “the state’s graduated-rate income tax would be largely replaced by a 5 percent payroll tax, plus an additional 2 percent tax on income above $200,000, which would raise more money than the current income tax. The state’s Earned Income Tax Credit (EITC) would be increased to offset the higher tax liability for low-income earners, and because the payroll tax is a deductible expense for businesses, taxpayers subject to the $10,000 [SALT] deduction cap would get a federal tax cut even as the state generates more money.”

Walczak’s article points out the main problems with the complicated proposed tax structure. Getting the thing to work at all without creating bizarre incentives is a problem. For example, a payroll tax with multiple brackets will inevitably require massive end-of-year adjustments for anyone working multiple jobs. It also results in a different tax structure for wage workers and independent contractors, as well as people who live off investments.

Does the Nutmeg State really want to shift the tax burden away from one group of people based purely on the terms of their employment? If so, regular jobs are going to shift to other states and freelancers are going to move in, creating a hole in the state budget. The idle rich will come out ahead, too, as their non-wage income becomes non-taxed.

That’s a strange thing for a supposedly liberal state to do, but ordinary concerns fly out the window when the overriding goal of thwarting the president enters the equation. Democrats have made a cottage industry out of saying richer people need to pay more taxes. When that becomes slightly true because of a Republican initiative, however, all of the well-heeled blue staters want to use corporations to hide income from the federal government.

Eroding Federalism For a Century Comes Back To Bite 

The pending case of New York v. Mnuchin, to which Connecticut is also a party, makes even less sense. The attorneys general of these four high-tax states suggest that the federal taxing power was never intended to interfere with the states’ taxing power. There is no citation for this point, which tells you about all you need to know: the claim is invented out of thin air.

The idea that the reduced SALT deduction impairs the states’ taxing power is also nonsensical; the states retain the power to tax, they just can’t use a federal deduction to hide how high their taxes are. As Joseph Bishop-Henchman wrote for the Tax Foundation, “Tax deductions and carve-outs are a matter of legislative grace.”

Even the idea that federal taxation must exempt all state taxes is unsupported by history. Bishop-Henchman cites several instances when the deduction was limited, including in 1964, 1969, 1986, and 1993. And from the start, federal tax never completely excluded state and local taxes: it was a deduction, not a credit. While taxpayers did not pay taxes on the portion of their income that they paid to their state, they did not get a full credit for that amount, either. The deduction only saves the marginal rate on the income devoted to state taxes—the fraction of the fraction.

The complainants say that “at ratification, it was widely understood that the federalism principles enshrined in the Constitution would serve as a check on the federal government’s tax power.” That’s true, but not in the way they think it is.

Federalism did result in informal limits on federal power, but only because the states, represented in the Senate, kept the federal government from fully exercising its powers at their expense. If those limits have been eroded in the past century, it is because progressives went out of their way to erode them, first by requiring the direct election of senators and later by appointing judges who allowed them to ignore all limits on federal power, written and unwritten.

These same progressives now want you to believe that one of those unwritten, informal restrictions must override the law. The change of heart is cynical, if predictable. Rich people in high-tax states are paying more federal tax, not because the federal tax rate has gone up, but because Congress decided to stop helping the states hide the effect of their unsustainable tax-and-spend policies. Those who destroyed the norms of federalism now wish the courts to re-erect them—but only insofar as it helps their friends.

It’s Not Fair!

All of these lawsuits and legal hedges are rooted in the same complaint: the rich blue states want to keep imposing high taxes on their people and want the federal government to help them obscure the consequences.Their argument here is that imposing the same rule on all taxpayers is unfair.

“By decreasing state tax revenue and making state taxes more expensive,” they write in the complaint, “the new cap on the SALT deduction will ultimately force the Plaintiff States to choose between maintaining or cutting their public investments and level of services, and the taxes supporting them. As such, the new cap on the SALT deduction directly and unfairly interferes with the Plaintiff States’ sovereignty, by depriving them of their authority to determine their own taxation and fiscal policies without federal interference.”

Their argument here is that imposing the same rule on all taxpayers is unfair. That’s a definition of “unfair” that only a small child could love. What it really means is, “I didn’t get what I want.” What they want, as the complaint plainly acknowledges, is to avoid making hard choices to balance their budgets. Every other state has had to make hard choices, but these four states don’t want to. Unfair!

Even if it were true that the law is unfair, this would be a political argument, not a legal one. Politicians on the far left want the courts to impose rules that the people and their legislators have rejected. Even their own statements confuse to whom exactly the law is unfair.

New York Gov. Andrew Cuomo attacked the tax law as one “that benefits the 1% at the expense of middle-class families.” But the loss of the deduction hits only those families who pay more than $10,000 in state and local taxes—hardly the average Joes Cuomo awkwardly attempts to evoke.

That’s Not How Any of This Works

This lawsuit will fail, and Connecticut’s too-clever workaround probably will, too. What happened in the Tax Cuts and Jobs Act of 2017 was a result that politicians from these four states found distasteful. It will force them to make the kind of hard choices that they were elected to make. It will make their previous bad decisions more obvious to their voters and put pressure on them to fix them. It will, in short, force them to govern.Twenty-first-century politicians will do nearly anything to avoid governing.

Twenty-first-century politicians will do nearly anything to avoid governing. The arguments are flimsy at best, and the remedy is uncertain. Asking the courts to strike down the partial limitation of a tax deduction is novel enough, but what comes in its place? Do they want the courts to impose taxes directly, an act that is at the core of a legislature’s functions?

They know this lawsuit is a damp squib, a feeble attempt to show the folks back home (and especially their rich donors) that they’re “doing something” to stop taxes on the rich from going up. Connecticut’s radical reform is somewhat better thought-out, but will certainly inflict unintended consequences on that state’s already struggling economy, even if the IRS doesn’t decide to ignore the whole shell game they are playing.

Like a child throwing a tantrum, they will flail and kick for as long as they can before finally having to do what they were elected to do: set a level of taxing and spending that their people can afford.