May 17, 2021

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A Tax Break for the Rich to Bail Out Profligate States

4 min read

Seventeen House Democrats from New York wrote their leaders April 13 threatening “to oppose any tax legislation that does not include a full repeal of the SALT limitation.” That’s an acronym for state and local taxes, only $10,000 of which are deductible on an individual tax return under the Tax Cuts and Jobs Act of 2017. The White House has signaled its openness to abolishing the cap.

“The SALT deduction was essential to New York and other progressive states,” the Empire State lawmakers write. Restoring it “would ensure that the state is able to recover as quickly as possible without sacrificing the benefits on which our residents rely.”

Democratic governors and local lawmakers dream of socialism without taxation, whereby local spending is partly financed by taxpayers from more fiscally prudent jurisdictions. Without the SALT-deduction subsidy, their policies become even more of a nightmare for taxpayers, who in growing numbers are leaving behind big-government states.

Reinstating the SALT deduction is meant to ease the pressure on high-tax states’ finances by shifting some of the burden to taxpayers in low-tax states, thereby reducing the incentive for taxpayers to move. It’s a political solution to an economic problem caused by politicians.

State and local governments are already highly misaligned in their incentives to tax and spend too much. More than a third of their total revenue comes from so-called intergovernmental transfers, which tilt trade-offs to favor government growth. The federal government pays the majority of the largest spending item on the state level, Medicaid. The 20% or so of President Biden’s “infrastructure” plan dedicated to Medicaid would only add to this problem, as will the bailouts of local governments in the American Rescue Plan, the most recent Covid relief bill.

All these measures raise a concern of moral hazard, the same problem we typically worry about for bailouts of banks. Failing government policies on the local level—from mismanagement of public-employee pensions to Covid lockdowns—would occur less if local taxpayers bore their full burden and therefore held elected officials accountable. Spreading risk across the country makes sense if uncertain losses aren’t under the control of the government officials, as say for natural disasters. But by subsidizing failure, the SALT deduction privatized gains and socialized losses for governments the same way bailouts do for financial institutions.

The SALT deduction is also regressive, benefitting mainly the rich in big-government states. Lower-income taxpayers usually don’t itemize deductions because the standard deduction (raised under the 2017 tax reform) is greater. Upper-middle-income taxpayers who did itemize lost much of the benefit to the alternative minimum tax, from which SALT isn’t deducted. The Tax Policy Center finds that the bottom 70% of the benefit of a repeal would go to individuals making $500,000 or more.

As the rich leave high-tax states behind, it makes clear that when governments charge a price more reflective of their size, those faced with the tab leave. Twenty-four of the 25 highest-tax states had net out-migration in 2016, even before the reform. Seventeen of the 25 lowest-tax states had net in-migration. The most departures were out of New York, whereas the most entries were to Florida, which has no state income tax. Post-2017 data aren’t conclusive yet, but these trends appear to have accelerated.

Good riddance, some leftists say. But you can’t finance big government without the rich. The top 1% pay 41% of state income taxes in New York, 37% in New Jersey, and 50% in California. When you redistribute wealth without concern for its source, you get less of it, partly because the rich leave but also because of reduced incentives to generate wealth. The result is evident in the immiseration of the poor by socialist regimes abroad. Taxpayers in these regimes vote with their feet too, leaving big governments behind. The most obvious fact revealing this is that socialist countries impose restrictions on people exiting, while freer countries on people entering.

These patterns were recognized before socialism hit U.S. shores with Covid. Trump’s Council of Economic Advisers raised concerns in 2018 with a report on the nation’s early flirtation with socialism, now in full force. CEA is required by statue to promote free enterprise, but many economists were critical of the report as not being relevant to the U.S., when it has turned out to be very much so.

Taxpayers’ tendency to flee big-government jurisdictions should be taken more seriously, in the SALT cap debate and in economic policy more broadly. It is real behavior by those affected as opposed to the endless rhetoric offered by unaffected pundits and politicians. Defenders of these policies need to face the basic question: If big government is so good, why aren’t people willing to pay for it?

Mr. Philipson, an economics professor at the University of Chicago, served on the White House Council of Economic Advisers as a member and acting chairman, 2017-20.

Journal Editorial Report: Paul Gigot interviews economist Steve Moore. Image: Nicholas Kamm/AFP via Getty Images

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2021-04-27 18:17:00

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