A Tax Break for the Rich to Bail Out Profligate States

Regressiveness plus moral hazard: There’s nothing to like about deductibility of state and local taxes 

By Tomas J. Philipson. He is an economics professor at the University of Chicago. Excerpts:

"State and local governments are already highly misaligned in their incentives to tax and spend too much. More than a third of their total revenue comes from so-called intergovernmental transfers, which tilt trade-offs to favor government growth. The federal government pays the majority of the largest spending item on the state level, Medicaid. The 20% or so of President Biden’s “infrastructure” plan dedicated to Medicaid would only add to this problem, as will the bailouts of local governments in the American Rescue Plan, the most recent Covid relief bill.

All these measures raise a concern of moral hazard, the same problem we typically worry about for bailouts of banks. Failing government policies on the local level—from mismanagement of public-employee pensions to Covid lockdowns—would occur less if local taxpayers bore their full burden and therefore held elected officials accountable. Spreading risk across the country makes sense if uncertain losses aren’t under the control of the government officials, as say for natural disasters. But by subsidizing failure, the SALT deduction privatized gains and socialized losses for governments the same way bailouts do for financial institutions.

The SALT deduction is also regressive, benefitting mainly the rich in big-government states. Lower-income taxpayers usually don’t itemize deductions because the standard deduction (raised under the 2017 tax reform) is greater. Upper-middle-income taxpayers who did itemize lost much of the benefit to the alternative minimum tax, from which SALT isn’t deducted. The Tax Policy Center finds that the bottom 70% of the benefit of a repeal would go to individuals making $500,000 or more.

As the rich leave high-tax states behind, it makes clear that when governments charge a price more reflective of their size, those faced with the tab leave. Twenty-four of the 25 highest-tax states had net out-migration in 2016, even before the reform. Seventeen of the 25 lowest-tax states had net in-migration. The most departures were out of New York, whereas the most entries were to Florida, which has no state income tax. Post-2017 data aren’t conclusive yet, but these trends appear to have accelerated.

Good riddance, some leftists say. But you can’t finance big government without the rich. The top 1% pay 41% of state income taxes in New York, 37% in New Jersey, and 50% in California. When you redistribute wealth without concern for its source, you get less of it, partly because the rich leave but also because of reduced incentives to generate wealth. The result is evident in the immiseration of the poor by socialist regimes abroad. Taxpayers in these regimes vote with their feet too, leaving big governments behind. The most obvious fact revealing this is that socialist countries impose restrictions on people exiting, while freer countries on people entering."