Why four states think they can win their suit against tax deduction caps

A Civil War-era revenue measure is the centerpiece of a lawsuit filed by four northeastern states seeking to block the $10,000 annual cap on federal tax deductions for state and local taxes.

New York, New Jersey, Connecticut and Maryland sued the Trump administration Monday over the sweeping tax changes enacted in December's tax reform legislation, arguing that the SALT deduction since its inception in 1862 has served as a valuable tool to avoid “double taxation.”

Dan Nelken/Dan Nelken

The suit cites the federal income tax imposed during the Civil War in 1862, which was repealed a decade later. The SALT deduction was a centerpiece of that measure, the lawsuit says, "because the deduction was necessary to ensure that the federal tax did not burden the States’ own ability to raise tax revenue."

The states also argued in the lawsuit, filed in the U.S. District Court for the Southern District of New York in Manhattan, that the sweeping tax changes targeted "blue" states with more Democrats. All voted for Hillary Clinton in 2016.

“The SALT deduction is essential to prevent the federal tax power from interfering with the states’ sovereign authority to make their own choices about whether and how much to invest in their own residents, businesses, infrastructure, and more,” the suit states. “It deliberately seeks to compel certain States to reduce their public spending.”

The suit, which was first announced in late January, cites a fiscal analysis showing the SALT deduction cap is projected to raise the federal taxes of New York homeowners by $14.3 billion in 2018 and $121 billion between 2019 and 2025. The complaint also notes that the average SALT deduction claimed by the 3.3 million New York taxpayers who itemized deductions on their federal tax returns was $21,943 in 2015, the most recent year for which tax data is available.

The SALT deduction cap is the primary driver behind net increases toward federal taxes of 13% in New York, 12% in Maryland and 11% New Jersey compared to just 5% and 2% of taxpayers in Florida and North Dakota, respectively, according to the suit. Connecticut Gov. Dannel Malloy said Tuesday that his residents stand to lose $10 billion in SALT deductions.

“The 2017 federal tax law, which resulted from a hyper-partisan and rushed process, drastically reduced the deduction by capping it at $10,000,” said Malloy in a statement. “The cap will cause Connecticut taxpayers to lose an estimated $10.3 billion in SALT deductions in 2018, and will increase Connecticut taxpayers’ federal income tax liability by approximately $2.8 billion in 2018.”

An April report from Moody’s Investors Service said that the SALT cap limit would likely dampen housing price growth in states with high percentages of individuals claiming the deductions, which would thus limit property tax revenue growth. Moody’s also noted that municipalities with high fixed costs will face increased revenue challenges because they have less discretionary spending to cut.

Joseph Bishop-Henchman, executive vice president of the conservative-leaning Tax Foundation, wrote in an analysis Tuesday that it isn’t “unprecedented” for Congress to limit the SALT deduction, pointing to multiple changes over the last half century. He noted that in the deduction was changed from applying to all state taxes to only certain ones and in 1986 it was limited to only income and property taxes.

“It’s not frivolous, but I’d call it meritless,” said Bishop-Henchman of the lawsuit. “The SALT cap disproportionately impacts high-tax people in high-tax states, but that is not a constitutional violation.”

Michael Leachman, senior director of state fiscal research at the liberal-leaning Center on Budget and Policy Priorities, said he couldn’t speak to the merits of the federal lawsuit but said “the changes at the federal level obviously do have an effect on the ability of states and localities to raise revenue that they need.

“The federal tax changes were a windfall for the very wealthy and for corporations and the top 1% are in fact getting about $80 billion this year alone from the federal tax changes,” Leachman said.

Leachman conceded, however, that the new $10,000 cap on SALT will make it harder for governments to raise property taxes.

The tax changes prompted states to explore workarounds to minimize the negative effects on homeowners. New York lawmakers enacted legislation allowing charitable trusts to accept tax deductible payments in lieu of municipal taxes and enabled employers to implement a 5% payroll tax to help pay some of their employees’ state income taxes. New Jersey implemented a similar law allowing charitable contributions to local governments and also increased the state’s own income-tax deduction for property taxes to $15,000 from $10,000.

The Internal Revenue Service announced May 23 it is working on regulations to enforce that cap.