Sunday, March 18, 2018

The Republican Tax Reform: Part 12–The New Limit On SALT Deductibility

Another feature of the Republican tax reform is the new limit on the deductibility of tax payments to state and local authorities (SALT). Previously, there was no limit on this. Now the limit is $10,000.

The U.S. has a more seriously federal system of government than most countries. "Federal" is the word that means layers of government that have some ability to operate independently of each other. Just to confuse things, we also use the word federal to denote the top level of government at the national level.

So, in the U.S., the Federal government's big roles are defense and collecting tax revenue. A lot of that tax revenue is paid out as transfer payments to individuals (like social security), but some is transfer payments sent out to states to provide services to individuals (like Medicaid). States actually provide a lot of healthcare, as well as funding transportation projects and universities. Cities and counties to a lot of healthcare too, while school districts provide K-12 education.

Not all states have an income tax, but most do. Localities, mostly cities, towns, and school districts, also levy property taxes.

In most places, people file two income tax returns: a federal one and a state one. Then most people make a third payment, often included in their mortgage payment, for property taxes.

On income taxes, there are adjustments, exemptions, and deductions. Adjustments are for items that are or are not counted in income. For example, alimony payments from a working divorcee to their (often non-working) former partner lead to a downward adjustment if you are paying (because you don’t benefit from that income) and an upward adjustment if you are receiving (because you do benefit from that income). Exemptions are for everyone: they are a certain amount taken out of your income on which no tax is owed. Exemptions are the same for everyone: for example, rich or poor, if you have a child, they knock about $4K off your taxable income. No one asks what you spent that money on. Deductions are a little more complex. These are specific stipulations that some things that you spend money on also may be subtracted out of your income before taxes are calculated. The big categories for deductions are interest paid on investments, charitable contributions, out-of-pocket healthcare expenses, job expenses, monetary losses to casualty (for example, uninsured storm damage) and theft, and state and local taxes.

The rough idea behind deductions is that these are expenses that induce changes in someone else's income (that will also be taxed). Someone else could be another person, but it could also be the future you. So, interest on investments is deducted because you are giving up some income now to make more income later on (mortgage interest and points fall in this category). Charitable contributions often provide income directly to someone else (like supporting an artist with cash), or indirectly (like tithing being used to pay the income of church employees), or substitute for someone earning income (like food donations). The intention is always that if the government can track where that income went, they'll tax it there: more on that later. Healthcare expenses are deductible because getting healthier now may help you earn more income later. And casualty and theft losses are claims on things that have to be replaced, often out of current income, to earn more income in the future.

Donations to charity are worth a deeper look. Hypothetically, you could do something like this. Set up a charity to which you donate. Use the charity to buy things that are difficult to tax. Then donate those items back to yourself. This avoids the income tax on those items: if you bought them directly, you'd be spending income that had already been taxed. For obvious reasons, this sort of behavior is defined as (illegal) tax fraud rather than (legal) tax avoidance. What is legal is to make a donation and receive back something of value, as long as you subtract that value off your donation. More on this later. Also note how different this is from the deductibility of interest income: with charity you may be able to deduct the whole expense, whereas with investments you can only deduct interest if you borrowed, and not the value of the asset you invested in and will sell later on.

I do not know the history, but somehow tax payments made to state and local authorities were added to the list of deductible expenses. This is not completely dubious. For example, you pay taxes that support education, which in turn may help your kids earn higher incomes (which will be taxed later on). Fair enough. But do note that you're getting an indirect benefit here. So this case is fairly close to that of charitable contributions, in that the best justification for this deduction is if it is on the net rather than gross amount.

Of course, there is also the counterargument that while the rich pay more taxes, it isn't clear that they get back in benefits what they put in. This is a cornerstone of the progressive principles that underlie most social policy.

But, now we're on to something. Taxes that pay for things that make you or someone else more productive probably shouldn't be deductible, but taxes that go to certain social programs probably should be.

The big question would be how to divide those two. It's not clear there's a decent answer for that. The precedent is that it's all been deductible.

In this case, the Republican tax reform at the national level can be seen as a slap at the states and localities with more progressive government policies. These tend to be in the northeast and on the west coast. And those are mostly blue states that have voted against Republicans for a couple of decades, and urban areas that have voted against Republicans for almost a century. Politically, the limit on SALT deductions is absolutely a slap in the face of these areas.

All of the above is prologue. What I'm really interested in here is the macroeconomics.


Macroeconomically, we think of government as a pass-through. It produces little or no income from productive efforts on its own. But it does draw off income from productive sources. That's bad. But it also passes through that money and spends it on stuff produced in the private sector. The question is if that stuff is good enough to make the taxation worthwhile.

Microeconomically, we think there are some good things to spend money on, primarily public goods. The tough question is drawing the borderline between a public good that would not be available without the government, and a private good that might be.

Macroeconomically, Keynes asserted that there was a multiplier process that amplified some government spending. A multiplier larger than one indicates that government spending is beneficial (after netting out the negatives of taxes). Currently, a point estimate of 1.5 for the multiplier is widely accepted. What is not clear is how why the confidence interval is on that.

However, there's an important caveat on that multiplier process. It only works on spending that is autonomous. That's defined as spending that's unrelated to the income of individuals who might benefit from the policy. For example, Warren Buffet can afford steak, but is known for eating hamburgers. Roughly, if he would not buy a steak on his own (even though he can afford it), if the government buys him a steak rather than a hamburger, the difference in the price is autonomous. That's a frivolous example, but it extends readily to things like bridges or military equipment. The big questions come with stuff like education and healthcare spending. Is that autonomous too, even if someone would pay for it on their own if the government didn’t provide it for them?

Do note that a problem of political discourse over the last few decades is that politicians of all stripes have lost sight of that autonomous spending argument. It's widely asserted that all government spending is beneficial because it is subject to the multiplier process. This is self-serving: if your job is to spend other peoples' money, who wouldn't assert that all your choices are positive ones? Keynes never claimed his theory supported all spending. A reflection of this is the interest of most politicians in infrastructure spending: everyone agrees that ought to be helpful as long as it's not stupid or extravagant. BTW: a useful way to think about contemporary China is as a big experiment in textbook Keynesian economics — heavily tilted towards infrastructure at the expense of social programs.

This is useful for contrasting the U.S. with western Europe. It's often decried that the U.S. is less progressive because out government does not spend as much. (Do note that there's a huge pitfall here if you count only the national government, since the U.S. system is more federal than most European ones). This difference is often attributed to social programs. To the extent that is correct, the extra social programs are doing nothing to promote growth. This goes some way towards addressing the inability of most western European country's economies to grow as fast as the U.S. over the last generation or two.

Also, note that none of this is to say that social programs are not beneficial or desirable. I'm just making the point that there is little macroeconomic theory suggesting that they do much to alleviate business cycles or promote growth.

All of this leads up to a rather mind-blowing insight about the SALT deduction. To see this, consider archetypes of extreme conservative/Republican and liberal/progressive/Democratic positions.

In the extreme conservative/Republican view, government spending does no good at all. SALT is collected, but the money is completely wasted. In this case, the tax that was paid never helped the individual in the way that other income does. Yet income that doesn't benefit the individual is usually not taxed at all: like alimony paid. It's still hard to justify a deduction for SALT, but if you think government spending does little good it's easy to justify subtracting all SALT to adjust income. This is the opposite of what is in the Republican tax reform.

In the extreme liberal/progressive/Democratic position, government spending is better than private spending at providing benefits to society. But, if you pay SALT and receive benefits, this a reason to net out those benefits to reduce the SALT deduction (as in the case of some charitable contributions). Yet it is blue state Democrats who are complaining the most about the limits on SALT deductions. In fact, they are going so far as to propose special charities that taxpayers can donate to in order to get around the new deductibility SALT limits.

Through this lens, these two observations suggest that the SALT deductibility limits were a purely political move, with little economic meaning.

Personally, I come down on the liberal/progressive/Democratic side that quite a bit of government spending is actually helpful to the economy. Unlike those groups, my principles tell me it is a good thing to cap or even eliminate the SALT deduction. It's basically a way to get extra government services for your locality, while you pay a discounted price and others pick up the difference.

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