The Grumpy Economist: SALT margins

The Grumpy Economist: SALT margins

I think most of the debate misses an important point about the state and local tax deduction — incentives.

Suppose you are in the top, (roughly) 40% marginal federal tax bracket.  If you pay an extra $100 in state taxes, you deduct $100 from income, and pay $40 less in federal taxes. So, you really only pay $60 in state taxes. The federal government effectively transfers $40 to the state from taxpayers in other states.

That’s a big incentive to raise money as deductible taxes from high-bracket tax payers! This incentive doesn’t work if the state raises taxes from lower bracket taxpayers.

California’s tax system, for example, seems to respond heartily to this incentive. California’s income tax rate is highly progressive, topping out at 13.3%.  As reported in the Sacramento Bee

Nearly 90 percent of the money [income tax receipts]  comes from one-fifth of the taxpayers – those making $91,000…Forty-five percent of the state’s income tax money comes from the top 1 percent of filers – those with adjusted gross income of at least $501,000.

and, therefore, in the highest Federal tax bracket, and also likely to itemize deductions.

The state of California relies a lot on income taxes. The
state of California gets 65% of its revenue from individual income taxes, 22% from sales taxes, and 8% from corporate taxes.

Property taxes in California raise about $60 billion, roughly equal to the total raised from personal income taxes.  Since the state is home to extremes of housing values, thanks to land use and building restrictions, property taxes are also raised largely from people in high tax brackets, and therefore benefiting from the 40 cents on the dollar subsidy from the rest of the country. (This is a guess. If you know of data on property tax by income brackets, I’d like to see it.) (Update. This is totally wrong, but I’ll own up to it rather than delete it. See next post.)

The usual stories about California rest on its progressive, redistributionist politics, and there is certainly much of that rhetoric around. But it also happens to be responding perfectly rationally to a strong incentive.

Conservatives have long objected to governments that spend other people’s — taxpayers’ — money unwisely.  But money raised from taxpayers from other states, who do not vote in your elections, provides doubly bad incentives.

This strikes me as a potent economic argument against deductibility of state and local taxes, that hasn’t been made loudly enough. Of course no argument (pro or con) based on incentives has been made loudly enough!

This strikes me as theme of many things needing reform America. The New York Times  report on astounding infrastructure costs rang a nerve. Most infrastructure is directed by state and local officials, who spend Federal money.  Medicaid remains a matching fund — the state spends a dollar, the federal government chips in a dollar.  The move to turn it in to a block grant, which failed last summer, would have removed this incentive.  Federal money and state control is a common pattern in social programs, and John Cogan explains well the legal and institutional reason for this separation in our history. But it leads to atrocious incentives.

Perhaps a general reform lesson is that states should have to raise the marginal dollar for anything from their own voters.

PS. I was long for the deductibility of SALT on the grounds that it keeps down the total tax rate. If both federal and state charge 50%, with deductibility you keep 25% of your income (Federal takes 50%, state takes 50% of what’s left, so you have 25%.) With hundreds of different taxes, it is possible to exceed 100%! However, I’ve been persuaded these incentives are more important. Moreover, if paying twice is such a problem, dear California, you can make federal tax payments deductible from state income. I do not hear a groundswell for this solution.


A few commenters (and by email) claim that California pays more to the federal government than it gets back. The point is not the overall subsidy, the point is on the margin. A marginal $100 leads to a marginal $40 cross subsidy, no matter who pays who on average.

Also do not confuse margins and levels for people. The loss of SALT deductibility hurts a lot less on average than on the margin. Someone paying 13.3% marginal state tax in California only pays that rate on income over $1,000,000. So their total loss from the loss of SALT is not equivalent to paying federal taxes on the full 13.3%.


A reader sent me links to two wonderful resources, “real estate taxes paid by income bracket, and by state, available as part of the IRS Statistics of Income:

California here: (Lines 74-75)

All states and national summary here: (Lines 75-76)

Individual state files and additional data:

From the California analysis:

The row “real estate taxes, amount” and following addresses the question I asked in the blog — to what extent is the apparently flat property tax actually progressive? It’s not as much as I thought. The top two categories pay 37% and 14% of real estate taxes, though they bay 72% and 49% of income taxes. (The table verifies the state numbers on how concentrated California’s income tax receipts are.) In retrospect, even overpriced real estate is a normal good — people don’t pay larger fractions of their income on real estate as they get more income — so a flat real estate tax will raise more money from people with higher incomes, but not a higher fraction of income.

The table is fascinating, and a clear mine for blog posts. One big lesson that sticks out to me (ok, confirmation of something I’ve been mulling for a while) is just how meaningless income is as a social yardstick. Our policy discussions talk about “low income people” as if that is a permanent caste distinction. Yet look how many people with million dollar incomes are taking unemployment compensation! In the next row, just who are people with under $1 of income? You imagine homeless people roaming the streets of San Francisco. Well, of the 286,000 such people in California 51,000 are s-corporation owners who lost money, collectively $5 billion.

Update 2 

Morris Davis sends along the following data on property tax / household income.

Just how much are property taxes as a fraction of income? It’s interesting for a lot of reasons. For one, total taxes  matter to the economy. Too many commenters decide that the top federal rate of 42% (last year) is low and we ought to tax people more. They forget state and local income taxes, sales taxes, excise taxes, corporate taxes, etc. etc. And property taxes.

Granted, we’re veering off topic here, but here is the table. New Jersey, where Morris lives, has the highest tax rates. California is up there, but proposition 13 and a lot of low-priced inland areas must offset ridiculous house prices in the coastal areas.

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