Getting Business or “C” SALT Right

Lawmakers are currently considering a limitation on the business deduction for state and local taxes paid (C-SALT). There has been some concern that this would be a mistake. Doug Holtz-Eakin, for example, argues that state and local taxes are properly deducted as the cost of doing business. While a helpful framework in some cases, the issue is more complicated in the context of state and local taxes. There is a case for some limitation.

The Tax Cuts and Jobs Act (TCJA) limited the itemized deduction for state and local taxes for individuals to $10,000. The case for this limitation is straightforward. Most state and local taxes represent transfers to recipients of state and local benefits. These benefits are income while the taxes represent “anti-income.” The income tax does not apply to benefits. Thus, a deduction for the taxes paid is improper and encourages higher state and local taxes and spending.

The limitation applied to state and local income taxes paid by owners of pass-through businesses. However, the TCJA left in place the above-the-line deduction for business taxes paid such as entity-level income taxes, property taxes, and sales and excise taxes.

This was intended, but lawmakers are right to ask whether this treatment is correct.

To determine whether the deduction for business taxes should be limited, the question that lawmakers should consider is: given that the individuals face a limitation, what is the economically equivalent treatment for businesses?

The goals are to avoid favoring certain forms of state and local taxation over others and to limit the extent to which states and localities are able to game the system.

The right answer depends on the tax and its incidence.

There is a good case to limit the deductibility of taxes that are economically similar to the individual limitation. For example, entity-level taxes on pass-through businesses are not much different than the individual income tax on pass-through business profits. It is not clear why one tax should be deductible but the other should not.

Other taxes, however, are properly deductible. State and local excise taxes, which generally result in higher prices in the taxing jurisdiction, are included in the gross receipts of businesses. If the federal government disallowed a deduction, the federal government would penalize this form of taxation. Corporations would face $1.21 in taxes for each $1 in state and local excise taxes paid.

Some payments to state and local governments, such as taxes or fees for specific services are more directly attributable to a business’s production process. There is a case for deductibility of these fees. A deduction for a toll paid by a trucking company or payment to a state-owned utility would ensure parity with the treatment of the same good or service if it were privately provided.

A limitation does come with complications, but those should be weighed against the benefits.

As mentioned above, the extent to which a limit on deductibility results in neutrality depends, in part, on a tax’s incidence. If the incidence of a tax is unclear, it could lead to imperfect treatment. For example, if we thought a portion of the state and local corporate income tax results in higher prices like an excise tax, some of the tax should be deductible to maintain neutrality with non-deductible individual taxes.

Limiting the deduction may not result in perfect treatment for any given tax. However, treating economically similar taxes similarly will limit states’ and localities’ ability to game the federal tax code and would avoid favoring one tax over another. Leaving entity-level income taxes deductible while disallowing owner-level income taxes favors corporate income taxation over individual income taxation of pass-through businesses. It has also led to the proliferation of pass-through business SALT workarounds, which will cost the federal government around $200 billion over the next decade.

A limit on the deduction for state and local corporate income taxes paid would increase the all-in federal, state, and local statutory tax rate on corporate profits from 25.8 percent to 27 percent. Similarly, a limitation on property taxes paid would increase the net property tax rate on business property.

This would have real economic effects, but could be offset with other pro-growth policies such as accelerated depreciation.

Furthermore, scaling back the state and local deduction for business taxes would raise at least $200 billion over a decade, which would offset some of the cost of extending the TCJA’s individual provisions.

The argument that because the corporate tax is a tax on net income, expenses should always be deductible is unsatisfactory. It does not answer the question lawmakers should be asking, which is: what is the proper definition of net income? The answer is more complicated than some suggest.