Four Blue States File Dubious Lawsuit Against Cap on Federal Tax Deduction for State Tax Payments [updated with brief response to Michael Ramsey]

The lawsuit contends that the Constitution requires a federal tax deduction for "all or a significant portion" of state income tax payments. It relies on badly flawed constitutional arguments to try to prop up a badly flawed policy.

I support many of the lawsuits filed by blue states and localities against the federal government, such as those seeking to protect "sanctuary cities" against federal coercion and commandeering. But I cannot say the same for the suit recently filed by the states of New York, Massachusetts, Maryland, and New Jersey which seeks to invalidate a provision of the 2017 GOP tax reform law imposing a cap on federal tax deductions for state and local tax payments. Previously, taxpayers could deduct all state and and local income and property taxes from their federal tax returns. Under the new law, the State and Local Tax (SALT) deduction is capped at $10,000. This measure is likely to disproportionately affect wealthy people who live in states with high state income taxes (most of them blue states). For that reason, it's understandable that the blue state plaintiffs are unhappy about the change. But their legal argument against the new policy borders on the absurd. Moreover, it is ironic that progressives are defending a tax deduction that overwhelmingly benefits wealthy people and relatively affluent states, at the expense of poorer parts of the country.

In their recently filed complaint, the states argue that the cap on SALT deductions violates "the Tenth Amendment and foundational principles of federalism." They argue not only that the 2017 cap is unconstitutional, but that the federal government has a general obligation to exempt "all or a significant portion of state and local taxes" from the federal income tax. The problem with this argument is simple: nothing in the text or original meaning of the Constitution supports it. To the contrary, the Sixteenth Amendment gives Congress a general power "to lay and collect taxes on incomes, from whatever source derived." There is no mandated exemption for income used to pay state or local taxes. There is also no support for the states' position in Supreme Court precedent, or in the American constitutional tradition more generally.

The states point to various statements by framers and ratifiers of the Sixteenth Amendment indicating that the Amendment was not intended to impinge on the rights and powers of state governments. But none of these statements indicate that the federal government was required to create an exemption for state and local tax payments. The absence of such an exemption in no way diminishes states' powers to raise their income taxes as high as they want, although it might, of course, increase political resistance to high state tax rates.

It is also notable that the four states stop short of claiming that all state tax payments must be exempted, and merely claim that a "significant portion" must be. It is hard to say what qualifies as a "significant portion," and the states fail to explain why $10,000 isn't "significant" enough. Even among affluent taxpayers with incomes over $100,000 per year, the average claimed SALT deduction (among those who claimed it at all) was only $12,300 in 2014. The new cap of $10,000 sure seems like a "significant portion" of that, at least to me. And, of course, few if any taxpayers with incomes below $100,000 are likely to exceed the cap.

The states also argue that the new law undermines the "equal sovereignty" of states because it disproportionately hits blue states with relatively high income tax rates. This disproportionate effect is surely present. But similar disproportionate impacts occur with pretty much any tax deduction formula. The very existence of the SALT deduction negatively affects poorer states and those with lower state tax rates, because it forces them to bear a higher proportion of the total federal tax burden. In a diverse nation with states that have a wide range of policies, almost any federal tax deduction will disproportionately benefit some states at the expense of others.

Admittedly, blue states are not the only ones who have advanced extremely dubious arguments in recent litigation against federal policies. Badly flawed as they are, the blue state claims in the SALT case are probably no worse than the ridiculous severability argument advanced by twenty red states (and now, also, the Trump administration) in the currently ongoing Obamacare case. But the bad behavior of many red states and Trump does not justify that of these blue states (or vice versa).

Legal considerations aside, it is unfortunate that some progressives are defending a policy that effectively creates a federal subsidy that mostly benefits the wealthiest residents of the wealthiest states. Only those who itemize their tax deductions (as opposed to taking the standard deduction) can even use the SALT deduction at all, and only about 30% of households (mostly affluent ones) did so in 2013. That figure is likely to decline greatly when the 2017 law takes effect, because - among other things - it doubles the standard deduction. The remaining itemizers will be an even more affluent group than the previous ones. Even under pre-2017 law, some 75% of the benefits of the SALT deduction went to households earning over $100,000 (median household income was about $57,000 in 2016). The states with relatively high state tax rates that get the lion's share of the benefits from SALT are mostly relatively affluent themselves, compared to other states.

Perversely, the SALT deduction undermines both efficiency and equality at the same time. It effectively creates a federal subsidy for high state and local tax rates, thereby skewing state governments' incentives. From an equity point of view, the subsidy overwhelmingly helps the wealthiest residents of some of our wealthiest states, thereby shifting a higher percentage of the federal tax burden to poorer people and regions of the country.

If the Republicans created a special tax deduction that benefits wealthy residents of wealthy areas at the expense of the rest of the country, liberal Democrats would (rightly) line up to condemn it. Yet the SALT deduction the blue states seek to restore to its former level does exactly that. The 2017 GOP tax bill has significant flaws, most notably its long-term fiscal irresponsibility. But the Republicans were right to cut the SALT deduction. Indeed, it might have been even better to eliminate it entirely.

Blue state governments understandably fear that cuts in the SALT deduction might lead some affluent taxpayers to leave for states with lower taxes, thereby reducing tax revenue. But there is much they can do to expand their tax base without relying on special federal tax deductions for the wealthy. For example, they could cut back on the restrictive zoning rules that artifically inflate housing prices and cut off large numbers of middle and lower class people from valuable job opportunities. As experts across the political spectrum have argued, doing so would enormously benefit poorer Americans - and greatly increase economic growth and tax revenue for blue states.

UPDATE: Prof. Michael Ramsey comments on the case (and this post) here. He agrees that the four states' lawsuit should ultimately fail, but argues that I have been too quick to dismiss it:

Originalism (in some versions) does accept arguments based on structure and background understandings. (I believe Professor Somin is a defender of Justice Scalia's opinion in Pintz v. United States, which relies on such arguments). So I would not be as dismissive. But in the end I think he's right.

In my view, the anti-commandeering rule the Supreme Court endorsed in Printz is in fact justified by the text of the original Constitution: specifically the original meaning of the word "state," as explicated in this valuable article by Michael Rappaport. Thus, there is a textual basis for the result in Printz, while the current state lawsuit lacks any similar textual foundation. But even if we consider original understandings of "structure and background" that are completely disconnected from any specific text, the states still fail to present any evidence that those understandings specifically required exemptions for state and local taxes. None of the historical statements they cite indicate any such thing.