Now that the feds have limited the state and local tax (SALT) deduction for individuals, should New York’s no-longer-fully-deductible personal income tax (PIT) be converted into an employer payroll tax?
That idea is being floated in some quarters as a way to circumvent the fiscal impact of the new federal tax law’s low-SALT diet in high-tax states. In New York, the curtailment of SALT deduction will result in net tax hikes for a relatively small number of (mainly very high income) filers who now pay a disproportionately large share of state taxes.
A report in Sunday’s New York Times said Democrats in some states, perhaps including Governor Cuomo, were considering proposals to “replace state income taxes, which are no longer fully deductible under the new [federal] law, with payroll taxes on employers, which are deductible.”
**UPDATE: Sure enough, Cuomo’s 2018 State of State message includes a promise to “explore the feasilbity of a major shift in tax policy and are developing a plan to restructure the current income and payroll tax system, as well as create new opportunities for charitable contributions to support public programs.” (Also: see PS at end of post.)
The idea of replacing all or part of the state PIT with a payroll tax, partially subsidized by the federal government via business tax deductions, might sound plausible or even appealing on the surface to politicians worried about the impact on their revenue cash cows.
But on closer inspection, even taken on its own terms, the payroll tax idea is not nearly as simple as it sounds. In fact, any attempt to broadly displace the PIT with a payroll tax would be fraught with mind-bending complications and virtually impossible to implement.
The remaining question is whether even a narrower tax aimed at preserving federal deductibility, such as a targeted employer tax on salaries above a given high level, could be shaped in such a way as to (a) cleanly offset the impact of the SALT deduction loss on higher-earning New Yorkers without (b) effectively raising overall state taxes and creating new, counterproductive economic distortions and inequities.
Different tax scales
Existing federal, state and local payroll taxes are imposed at a flat rate. But New York’s existing income tax—which a payroll tax would need to fully or partially replace, under the scenario suggested by the Times story—is steeply progressive, imposing higher rates on higher incomes, with special added tax breaks based on marital status and family size. (Through a complicated “recapture” provision, the PIT produces a progressive distribution even while being imposed on individuals as a flat tax in various brackets, starting as low as $100,000.)
Taxing all salaries at the same level—indirectly taxing the workers themselves, of course—would inevitably create a new class of winners and losers, even in the same income brackets.
Take for example, two employees of the same company, working side by side in identical job titles paying a salary of $75,000. One employee is a married man whose wife stays at home to care for
two three children under age 17. The other employee is a single person. Under current law, the New York State PIT bill for the married worker with children comes to $2,000, an effective rate of 2.7 percent, while the taxes for the single worker with no dependents is about twice as much, at $3,989, an effective rate of 5.3 percent. A standard payroll tax would cost both employees the same amount.
There are countless variations to this scenario. In any given establishment, even a top-heavy company whose workforce is comprised largely of highly paid professionals and technicians, a group of two or more employees might be currently subject to effective rates ranging from as low as zero to a little more than 6 percent—or, in rarer instances, even higher than 8 percent, in the case of workers earning more than $1 million.
The only conceivable way to roughly replicate progressive PIT rates across the board, without forcing employers to eat the differences, would be to create something very unusual: a progressive payroll tax with rates varying by individual worker based on family size and marital status information employees report on their W-4 withholding certificates. Businesses (not to mention the state’s own tax collectors) would no doubt find this added administrative burden intolerable. It’s difficult to imagine any state would get far trying to impose such a system.
Who wants a pay cut?
An imagined payroll tax in place of PIT would also require cooperation from workers themselves. After all, a payroll tax would simply become an additional tax on business unless the amounts now withheld and sent to Albany for PIT were instead withheld by employers themselves to pay the new tax.
Workers would have to accept what amounts to a gross pay cut, trusting that their take-home pay would not change during the crucial transition point at which, simultaneously, (a) the PIT is fully or partially eliminated, and (b) employers begin withholding the money at the firm level for payroll taxes. In unionized workplaces, including virtually all of state and local government, this would be a point of contention.
While proponents of the payroll tax idea assume it could be deducted by all employers, it’s still unclear whether corporate pass-through entities subject to New York City’s unique Unincorporated Business Tax could continue to deduct anything other than their property taxes on federal tax returns.
What’s more, it doesn’t take account of the government and nonprofit sectors, which don’t pay taxes and thus have would nothing to deduct if required to collect payroll taxes. Government alone accounting for 14 percent of total payrolls in New York State as of 2016, and the largely non-profit and higher education would add to that share. Until this year, government and privatel employees alike had their state income taxes effectively subsidized by the federal SALT deduction—assuming they claimed it, that is (65 percent of New York income tax filers didn’t).
Any payroll tax on government employees won’t be subsidized by the federal government via a tax break but will simply be an added cost to the state government—unless, again, the workers agree to take a pay cut calibrated to equal what they now pay in state PIT. It’s far more likely that this will happen first.
Splitting the income difference
As of 2014, wages and salaries represented two-thirds of the total federal adjusted gross income of New York State residents—but less than one-third of the income reported by state residents earning $1 million or more. The rest consisted mainly of capital gains and business partnership profits, which would be untouched by a payroll tax. Because so much of the state’s net taxes are generated by investment and business incomes, it would take a payroll tax rate of almost 8 percent—considerably higher than the current PIT rate on anyone but income millionaires—to generate the same revenue as the PIT now does.
Advocates of the payroll tax solution could overcome that problem by retaining a progressive income tax on investment income while shifting to a payroll tax only on wages and salary income. Of course, this would defeat the supposed purpose of the whole maneuver, which is to offset the loss of SALT for all taxpayers regardless of their income mix.
In addition, roughly $100 billion of the $558 billion in wages and salaries included in New York’s PIT base as of 2014 was earned by residents of other states, who paid 15 percent of all net IT receipts. New Jersey and Connecticut residents alone generated $4.3 billion in New York PIT revenues, for which they were fully credited on their home state returns. But if New York shifts to a payroll tax, those commuters would effectively find themselves (indirectly) double-taxed by New York and their homes states. To protect them, New York, New Jersey and Connecticut would have to enter into a fairly elaborate tax treaty, coordinating their tax policies to a historically unprecedented degree.
The subsidy scenario
There is one way under which it would it might be feasible—and that would be as an addition to the PIT, rather than a substitute for any portion of the current income tax. The resulting revenue would be effectively redistributed to taxpayers directly, in the form of PIT rebates and credits, or indirectly in the form or an increase in, say, the School Tax Relief (STAR) property tax homestead exemption outside New York City.
Under this scenario, the key word here is “redistribute.” Such a new tax would simply be a different way of hiding or blurring the cost of New York government rather than reducing it. Like the existing PIT, it would disproportionately gouge both the highest and lowest paid New Yorkers in order to subsidize property tax relief for the comfortable (if heavily taxed) middle class.
Another, more workable scenario would be for New York to create a new state excise tax on very high salaries—higher, conveniently enough, than found in the public sector. Like a payroll tax, this presumably would be deductible on federal taxes for most private employers. It would also hit high-paid executives of nontaxable nonprofits.
A model exists on the federal level, in the form of the new tax law’s excise tax on the compensation of highly paid nonprofit executives. The state could impose a tax on all salaries and bonuses above $1 million and then return the money to the affected individuals in the form of an income tax credit, calibrated to offset the loss of their federal SALT deduction.
Here’s the problem: under the old federal tax code, the SALT deduction essentially was a discount equal to the marginal rate faced by itemizing taxpayers. So, for New Yorkers, the full SALT deduction represented a 39.6 percent discount on state and local taxes (not including the former, widely overlooked “Pease” limit on deductions, which effectively added a point to the net effective rate).
Under the new federal tax code, millionaire earners are losing a SALT deduction discount of 37 percent, which is the newly reduced top federal income tax rate. But under the new corporate tax schedule, the maximum deduction for employers will be 21 percent.
Therefore, even if the excise tax can be made to work in other respects, it will only claw back from the federal government a portion of the formerly available SALT deduction—unless the state is willing to dig deeper into its own revenues and, via the rebate or credit structure, deliver an actual tax cut to income millionaires. And it will still do nothing to reduce the new federal law’s effective tax rate increase on the two-thirds of high-earner incomes classified as capital gains and partnership profits.
A simpler way to do that would be to dispense with the excise tax and directly reduce the state’s own top rate.
Message of necessity
And all of these tortured calculations mask an important underlying fact: despite Governor Cuomo’s overheated rhetoric on the subject, the loss of SALT won’t mean much to the vast majority of New York taxpayers. As the Times story acknowledged:
Even in those states [New York, New Jersey, California and Connecticut], most residents will get a temporary tax cut because of other provisions of the law, including lower tax rates and an increase in the standard deduction. But the cap on the state and local tax deduction could pose a serious threat to state budgets, because it makes state taxes more expensive for residents. That could make it harder for states to raise taxes, particularly on wealthy residents, and could increase pressure to cut spending. [emphasis added]
To repeat: the biggest losers from federal tax reform are not middle-class families in general but a small number of very high-earners, mainly the income millionaires who have been Albany’s cash cows. A scattering of six-figure earners with highly taxed houses in downstate suburbs are also facing at least a small federal tax increase, but the impacts are so variable and inconsistent that it would be difficult to formulate a still-deductible state tax work-around benefitting only those who lose.
The bottom line: in the final analysis, any attempt by New York’s state leaders to adjust for or offset the loss of SALT through the creation of new, supposedly “deductible” taxes is unlikely to be worth the effort and distraction.
A simpler approach
These five first steps for responding to federal tax reform were outlined in my open memo to the governor and the Legislature yesterday:
- Decouple from federal law where necessary to preserve the existing personal income tax (PIT) structure, including state itemized deductions.
- Ensure the additional state “millionaire tax” rate is phased out on schedule at the end of 2019.
- Follow through on and if possible accelerate the middle-bracket PIT cuts already scheduled for phase-in between 2018 and 2025 (which will deliver its largest benefits to those six-figure, downstate suburban middle-class homeowners with the biggest SALT losses).
- Permanently enact the state’s cap on local property taxes.
- Complete the 2014 reform of the New York Estate Tax by eliminating the punitive “cliff” rates on the smallest estates still subject to taxation, recognizing that the new federal law will make New York more of an outlier in this area
In the final analysis, manipulation of the tax code should take a back seat to the highest priority of all: reducing spending by all levels of government in New York.
PS — On the other option Cuomo promised to explore, encouraging New York taxpayers to make deductible contributions to some contrived tax-exempt “charitable” front for state government would also require enacting some sort of accompanying reward, such as a tax credit equalling the amount contribute, or virtually no one would do it. Legally, this would seem to raise equal-protection issues. And if this gimmick is promoted aggressively by the state (for example, with official commercials paid for with state economic development funds) the IRS might disqualify it.