States and federal taxes

Republicans have a plan to hurt blue states. It could backfire.

Many blue states are in big, big trouble. Perhaps Republicans should be wary of causing them more, if they really think it through.

The new Republican tax plan is, on the whole, a bunch of tax cuts weighted toward the rich. To partly offset the cost of those cuts, the bill also closes some deductions and loopholes.

Among the biggest and most controversial of those disappearing deductions: all state and local income taxes. If Republican leadership has its way, the only state and local taxes you could continue to deduct on your federal personal income-tax return would be property taxes, and only up to $10,000.

This is not exactly a surprise. Red-state Republicans have complained about the state and local tax (SALT) deduction for ages.

They usually argue that the SALT deduction requires lower-tax, lower-income (i.e., mostly Republican) states to subsidize higher-tax, higher-income (mostly Democratic) states. They also complain that it incentivizes the latter to spend more on government services than necessary.

This critique is partly true. On the margin, SALT deductibility does make it easier for states and municipalities to raise taxes, since the feds implicitly bear some of the cost.

But the red-states-subsidizing-blue-states argument isn't quite right. At least, not when you consider the federal budget system as a whole — that is, how much states pay into the treasury in total and how much they get back through federal spending and transfers.

On net, tax dollars actually flow from higher-tax states to lower-tax ones, according to research from the Rockefeller Institute of Government. New Yorkers are effectively subsidizing Montanans.

But forget for a moment this red-vs.-blue scorekeeping. There's a much more practical concern that should weigh on federal lawmakers.

It's this: Many high-tax blue states are in serious fiscal doo-doo. And if Congress successfully repeals the deductibility of state income taxes, these states' fiscal challenges could quickly become a series of major (and possibly contagious) fiscal crises.

States are under fiscal pressure for a few reasons. The Great Recession, though it began almost 10 years ago, left budgetary scars that have not yet healed.

The bigger problem is what lies ahead.

As Stanford Graduate School of Business professor Joshua D. Rauh has documented, many states and municipalities bear huge unfunded pension liabilities. They've tried to hide them using accounting gimmicks (by assuming preposterously high returns on pension fund investments, for example) but eventually these debts will catch up to them.

Already, several states have experienced painful credit downgrades. New Jersey bonds have been downgraded 11 times since January 2010. Illinois's debt is barely above "junk" status.

These problems may be largely of these states' own making. Especially in New Jersey, where Republican Gov. Chris Christie looked at the state's budget problems and curiously decided to cut taxes.

But that doesn't make solving these states' debt problems any easier — especially under the tax regime that federal lawmakers are crafting.

"The elimination of SALT could have the effect of increasing pressure from taxpayers for states to reduce taxes," Rauh emailed me before the bill came out. "If creditors deduce the long-term impact of this, that could drive up borrowing spreads for states where this deduction is very valuable."

He added that the tax plan would likely "add further resistance and reduce willingness-to-pay when state and local governments propose future tax increases."

Which means these state and municipal fiscal problems can only get worse.

States could try to shift more of their taxes away from income taxes and toward property taxes, which currently comprise just 1 percent of states' own general source revenues. (Municipalities are much more reliant on property taxes.) But states don't have the administrative capabilities in place to easily do that, says Tax Policy Center senior fellow Tracy Gordon.

What's likely to happen instead?

Well, as the marginal cost of state and local income taxes rises, higher-income residents may decide to leave for greener (i.e., lower-tax) pastures. Or states may cut taxes to try to keep them around. Both possibilities would worsen states' fiscal imbalances and expedite the crises that are rapidly approaching.

It's not clear whether any of these risks are on the GOP leadership's radar. But if Republicans are hoping for some blue-state fiscal chaos, they shouldn't be, and not just because there are dozens of Republican congressional districts in Democratic states.

Democratic states, after all, aren't the only ones with enormous unfunded pension liabilities. If one high-tax blue state goes belly-up, investors could easily get spooked, driving up borrowing costs elsewhere, too. Fiscal fires can burn across state lines. So keep that schadenfreude in check.

Catherine Rampell's email address is crampell@washpost.com, Twitter, @crampell.

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