While Gov. Larry Hogan is formulating his plan to prevent the federal tax overhaul President Donald Trump signed into law last month from creating an unintended Maryland state income tax hike for potentially hundreds of thousands of his constituents, he might want to take a look at some of the fancy maneuvering leaders in other high-income, high-tax states are considering. The Trump tax bill’s limits on state and local tax deductions clearly make the legislation better for red states than for blue ones like Maryland. But tax experts have suggested a couple of loopholes that states could exploit to get around that, and policymakers in places like California, New York and Connecticut are paying attention. Maryland should, too.
At least two ideas for gaming the new law are getting some traction. One would essentially allow individuals to re-classify certain state and local taxes as charitable contributions. The GOP tax bill limits deductions for state and local income (or sales) taxes plus property taxes to $10,000, which is well below the average amount Marylanders who use that deduction now claim. But deductions for charitable contributions remain unlimited for those who itemize. Several states (including Virginia) already have programs that allow 100 percent reductions in state tax bills for donations to private school voucher funds, and while Maryland wouldn’t likely go for that (and shouldn’t), it could set up a similar system for donations to, say, public schools, limited to the amount by which the taxpayer’s state and local tax burden exceeded $10,000.
The other idea is a little more complicated but might have some ancillary benefits. It calls for states to eliminate their income taxes, and instead institute employer-paid payroll taxes in an equivalent amount. Such business taxes remain deductible, so that kind of switch could theoretically produce a scenario in which both the employer and employee profit. Because Maryland has a progressive state income tax, rather than a flat rate, and piggyback local income taxes based on where an employee lives rather than where he or she works, administration could be complicated, particularly for those who have multiple jobs. But the system would eliminate the need for workers to prepare local income tax returns, would provide benefits to taxpayers whether they itemize their federal returns or not, and could make Maryland a more attractive place for employers by reducing overall labor costs.
Employing one of those strategies would be good for taxpayers in Maryland (and New Jersey, Connecticut, New York, California, etc.), but bad for the nation as a whole in that it would greatly increase the overall cost of the tax bill. Of course, other loopholes in the legislation are likely to produce the same result whether states do anything or not. Those who can reclassify themselves as contractors rather than employees could take advantage of the much lower tax rates for pass-through corporation income. A variety of other provisions related to business expensing and international income will provide similar opportunities for many companies to lower their tax liabilities even more than Congress and President Trump intended. But avoiding the state and local tax deduction limit is the biggie in terms of gaming this legislation. The provision is expected to reduce the cost of the overall tax bill by hundreds of billions of dollars over the next decade, and without it, the bill would easily exceed the $1.5 trillion cap on the amount by which it could increase budget deficits.
What happens if the blue states with high local tax burdens, high housing costs and relatively high incomes go down that road? Quite possibly, they would force Congress to re-evaluate what was from the start a flawed piece of legislation — and given the likelihood that Republican control of the legislative branch won’t be any stronger after next year’s midterm elections than it is now, that should mean a bipartisan approach to reforming the tax code. Members of both parties could get behind an effort that actually simplifies the tax code, eliminates loopholes to broaden the base and lowers rates accordingly. If the leaders in states like Maryland could nudge Congress in that direction by looking out for the interests of their constituents, all the better.
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