Now that state income taxes aren’t going to be deductible, will states switch to payroll taxes?

As I understand it, the new federal income tax reform will stop people from being able to deduct their state and local income taxes from their federal income taxes.

Say, for instance, that you’re earning $100,000, you’re in the 28 percent federal tax bracket and you have a California income tax bill of $6,000. (For convenience, assume that 28 percent is your actual tax rate as well as marginal tax rate, and assume you have no other tax deductions; as I understand it, these assumptions don’t affect the change I describe here.)

• Under the old law, you’d pay $6,000 in California taxes, and then 28 percent of $94,000, which is to say $26,320 in federal taxes. You’d net $67,680.
• But when state income taxes become nondeductible under the new law, you’d pay $5,000 in California taxes, and then 28 percent of $100,000, which is to say $28,000, in federal taxes. You’d net $66,000.

The winner: The federal government. The loser: You. Another loser: California, which finds it harder to attract workers.

But say California replaces the state income tax (at least for employment income) with a state payroll tax that’s paid by the employer, and that it comes in at the same amount per employee. As I understand it, the payroll tax — like most other business expenses, such as salaries paid to employees — is deductible by the employer; and it’s not taxable income for the employee, because it’s not the employee’s income. If the employers then lower the salaries by precisely the amount that they’re paying in payroll tax, then we’ll be back to the old situation:

• You’d get only your reduced salary of $94,000 in income (and the employer would pay the state $6,000 in payroll tax), but pay no California income tax. You’d then have to pay 28 percent of $94,000, or $26,320, in federal taxes. You’d be back to netting $67,680.

That’s how I understand the thinking of University of Chicago professor Dan Hemel, who wrote about this last month:

If either the House or Senate bill becomes law, jurisdictions that now impose income taxes would be well advised to shift some of their revenue-raising to employer-side payroll taxes. …

Things get a little bit more complicated for states with progressive income taxes —but not that much more complicated. States like New York and California could impose an employer-side payroll tax pegged to the top marginal rate in the state and allow individuals to claim a refundable credit against state income taxes equal to the payroll taxes paid on their behalf.

The key point here is that a state, through a relatively straightforward legislative maneuver, could entirely negate the effect of the House or Senate proposal with respect to state and local income taxes paid on wage income (which is more than two-thirds of all household income). And given that this maneuver would make state taxes excludible for non-itemizers as well, the net effect could even be to lose money for the federal government.

One might ask why states don’t do this already. Even under current law, there are several advantages to states if they raise revenue through payroll taxes rather than personal income taxes: lower Social Security and Medicare taxes for all wage-earners; avoidance of the alternative minimum tax and the effects of the Pease provision for high earners; and exclusion of state taxes for workers who take the standard deduction. While it’s a bit of a mystery, the best explanation is probably that the benefits aren’t yet enough to motivate states to rearrange their tax systems, given that the people who pay the lion’s share of state income taxes are itemizers who can claim the SALT [that’s state-and-local-tax] deduction. Take away the SALT deduction for income taxes, though, and suddenly the motivation to shift away from a state income tax and toward a state payroll tax becomes much more powerful.

There would be obvious complications — for instance, if your employment contract (say, through a union) provides that you are going to be paid $100,000 per year, it may be that lowering the salary will violate the contract, even if the lowering is just a way of switching from state income taxes to state payroll taxes, and even if it ends up saving you money; it may take time to renegotiate those contracts. There would doubtless be others, too, for instance having to do with calculation of retirement benefits, provisions for various deductions within the state income tax, and the like. But the savings, both for the high income tax states’ citizens and for the state governments, may be substantial enough to justify dealing with all those hassles.

Now of course, if this reaction arises, Congress could go back and further change the federal tax law to treat state payroll taxes more like state income taxes. But it would take a good deal of effort, and there might not be the political will to make that change — especially if the Republicans lose their Senate majority in the next election.

I’m not saying that this reaction would be good for the country, bad for the country, just, unjust or anything else; nor am I praising or criticizing the new tax cut in general. (Just as a disclaimer, since I live in high-income-tax California, I likely would benefit from the payroll-tax switch I describe above; I’m not sure whether I’d benefit from the new tax plan in the absence of such a switch.) But I thought it worth mentioning, both as an illustration of how taxation and the reaction to taxation — private as well as governmental — can be a dynamic process, and as a preview of something that might be coming down the pike in the future.

Also, a much more important disclaimer: I’m very far from an expert on tax law (though Dan Hemel is such an expert), so please take what I say with a heaping tablespoon of state and local taxes.