The Story Behind the SALT Deduction: Federalism and Friction

Robert Goulder and Joseph Thorndike of Tax Notes trace the origins of the state and local tax deduction from its early role in defining state sovereignty to the politics that led to today’s cap.

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Credits
Hosts: Robert Goulder, Joseph Thorndike
Executive Producer: Paige Jones
Producer: Jordan Parrish
Editors: Christopher Trigo, Carolyn Kuimelis

Transcript

Robert Goulder: Is it smart to pit one state against another state?

Joseph Thorndike: Well, who decides what's smart? Some people who decide are tax experts. And for the most part, tax experts in this sort of modern era, not been huge fans of the state and local tax deduction, or really most itemized deductions.

Robert Goulder: Hello, and welcome to the podcast. I'm your host, Bob Goulder, contributing editor with Tax Notes. And joining me as always is Joe Thorndike. Joe is the history guy at Tax Notes. He runs our tax history project, which includes a timeline of major tax events and all available — publicly available — presidential tax returns.

And speaking of tax returns, Joe, today I wanted to talk about one of my favorite itemized deductions, the one for state and local taxes, which for better or worse, it's not the deduction that it used to be. It's been capped.

But before we get to the SALT cap, I wanted to back up and just figure out how is it that we ended up with this deduction in the tax code to begin with. I bet you know the answer, because I don't. But indulge me here, OK?

My initial thinking is that federal taxes are supposed to support federal spending, and state taxes support state spending, and the two really shouldn't be comingled. Now, that doesn't sound crazy, but they have been comingled. And how did we get here?

Joseph Thorndike: The thing about taxes is that they affect lots of stuff, including other taxes. There is a connection and it has to do with this deduction, which you mentioned, the state and local tax deduction, we're going to call it the SALT deduction —

Robert Goulder: SALT, yeah.

Joseph Thorndike: Because it's a nice way to shorten it, and it operates essentially as a subsidy for state and local governments. Perhaps that was the intent of it, but that's definitely the effect of it, and it manages to connect these two.

So let's back up and look, well, why do we have this thing in the first place? And the first reason is that when Congress created an income tax in 1862, at the very beginning of the income tax, they were concerned that this new tax might step on or encroach on the fiscal powers of the states. That if the federal government collects a lot of money, it might be harder for the states to collect money. And so, they tried to figure out, "How could we build something into this system that would prevent the feds from just grabbing up all the revenue from people?"

And so, actually, I'm going to read you a quote here from Justin Morrill, who was a member of the Ways and Means Committee in the House in 1862, and he says, "It's a question of vital importance to the states that the general government should not absorb all their taxable resources, that the accustomed objects of state taxation should in some degree at least go untouched. The orbit of the United States and the states must be different and not conflicting." And this is my favorite part. He says, "Otherwise, we might perplex and jostle if we did not actually crush some of the most loyal states of the union."

So this is really about protecting the states' rights to collect their own revenue in the way that they want.

Robert Goulder: So they were worried the states were going to be poor?

Joseph Thorndike: Yeah, and that they wouldn't have anywhere to go. So again, if the federal government sucks up all your income and puts a huge tax burden on you, that it might be difficult for the states to do that. So they wanted to create a little fiscal room, and we can talk later about how the deduction does that.

But the other reason that they created this at the time was that they wanted to avoid double taxation, or what they kept calling a tax on a tax. And the idea is that if people have already paid some money to the states for their property taxes, say, then they're not going to have as much money around to pay their federal taxes. So when we calculate those federal taxes, we shouldn't treat that money they've already paid out to the states as part of their resources. Otherwise, it's not fair, right? This is the argument, that otherwise you're taxing them on money that they no longer have control over. It's no longer theirs. And so, that's another big part of it, the effort to ensure ability to pay and to avoid double taxation.

This subsidy, this is how it works, basically the federal government allows you to deduct from your income — and this has been true since 1862 — anything that you paid to the states, and in the beginning it was quite broad, it was really any kind of tax that you paid to the states. And this would make the federal government essentially pay for some of that state spending. So the state is collecting money from you in order to pay their bills, to operate, to build roads or whatever else. And essentially, the federal government is going to subsidize that by collecting less money up at the federal level. So that's the subsidy. It makes it easier for states to collect this.

Robert Goulder: So it's not about helping taxpayers, it's about helping municipalities, states, and so on.

Joseph Thorndike: Right. And the taxpayers too, because otherwise you as a taxpayer would be paying more money, because you didn't —

Robert Goulder: The double taxation point.

Joseph Thorndike: Right. So it helps everyone. It reduces the cost of state and local government, and in the process maybe encourages state and local government to actually spend more, because they're like, "Well, it's OK, because our people won't have to pay the whole cost of this. The federal government is subsidizing it with this deduction. So hey, we can afford to spend a little more on roads. We'll build an extra road or a few more bridges or something like that."

Robert Goulder: More schools.

Joseph Thorndike: More schools, whatever it is. And so, conservatives have always felt like this is a subsidy for big government because it encourages states to expend more. Whereas the other side of that argument is that it's just recognizing the reality. States need to collect their money, people can't be taxed on it twice. This is where the argument really falls.

In the beginning, as I said, in 1862 they adopt this thing and very quickly they agree that basically you can deduct almost any kind of state tax. And over the years, that's been narrowed. You used to be able to deduct gas taxes, for instance, and you can't do that anymore. And then for a long time, you could deduct sales taxes, because states started to use general sales taxes, then they got rid of the sales tax deduction, then they brought it back and whatever. So which taxes that you can deduct has varied over time. In general, I think it's fair to say that the deduction has gotten narrower over time. They've gotten a little more careful about it.

Robert Goulder: So they're still subsidizing the states, just to a lesser extent?

Joseph Thorndike: They are. And the sort of key inflection points there would be around 1986, which is when they get rid of the sales tax, the deduction. Then they bring it back in, I think 2004, and then it becomes a permanent fixture in 2015. So again, back and forth, but their general tendency has been to narrow it because it's a really expensive deduction, right? Because so many people were claiming it, it's a very expensive deduction. And that gave Congress an incentive to kind of try to chip around the edges at it.

So again, let's talk a little bit about what you have to do. If you want to claim an itemized deduction like the SALT deduction or like the deduction for home mortgage interest or anything else, you have to itemize on your federal tax return. You have to fill out that extra schedule that says, "Here's all the things that I spend, and here's why I want to deduct them from my income."

Robert Goulder: They make you do a little bit more work.

Joseph Thorndike: They do. And it's a pain in the neck. This is where all the recordkeeping comes in for income taxes for the most part. In 1944 the income taxes suddenly — it used to be a rich person's tax, was paid by less than 10 percent of the population. During World War II, it becomes a big, broad-based tax that most working people are paying. And they say, "We've got to make this simpler, because this whole itemizing thing is kind of a nightmare. So we're going to create a standard deduction." Now, the standard deduction basically says, "Eh, don't bother itemizing. You can deduct X amount right up-front. We're not going to ask you to justify it, and you don't have to show us what you paid in taxes. You don't have to show us what you paid for your mortgage. This is how much you can deduct." It's a default deduction essentially.

Robert Goulder: If you're really bad at keeping records and receipts and invoices, then that's for you.

Joseph Thorndike: Right. And that's what most people do and always have done since that moment in 1944. The weird thing about it though, is that it makes an itemized deduction like the SALT deduction less important, because fewer people are going to claim it. So if you're providing a subsidy to the states, you're maybe doing a little less of that. It's not achieving the same policy goals it was intended to achieve. It's reducing the tax burden for that taxpayer, and sometimes in a very helpful way, because sometimes for a lot of people, the standard deduction is more than they could ever tote up on their itemized list, and that's why you would take the standard deduction. So when they create that in 1944, that diminishes the importance of all deductions in the federal tax system because a lot of people opt for it. And every time the deduction gets increased, that means fewer and fewer people are going to bother itemizing, and fewer and fewer of those deductions actually matter.

Robert Goulder: And necessarily it's less of a subsidy.

Joseph Thorndike: And it's necessarily less of a directed subsidy. It's sort of a general subsidy for taxpayers and everything they spend money on.

Robert Goulder: Is it wise policy to pit the interests of one state against another state? Because when you think about it, you get to have two people making the exact same income, writing out checks to the IRS for different amounts because of where they live. If they're in Massachusetts, it's a high-tax state, they're going to get a bigger deduction and pay less to the IRS compared to somebody in a low-tax state like Texas. Is it smart to pit one state against another state?

Joseph Thorndike: Well, who decides what's smart? Some people who decide are tax experts. And for the most part, tax experts in this sort of modern era [have] not been huge fans of the state and local tax deduction, or really most itemized deductions. And the reason is, well, there's several reasons. One is that they feel that it is the subsidy for sort of big government at the state and local level, that that's not necessarily something the government should be providing. It's just that's a choice that states and localities can make, that they want to offer more services, and then their residents should actually just pay for that. Rather than having the federal government and by extension, people around the country, taxpayers around the country subsidize that for them. So they just feel like that sort of disparate subsidy for bigger government, that's not a good idea.

The other reason that experts don't really like this deduction and never have, is that for the same reason they don't like a lot of deductions, which is that they tend to be much more valuable for rich taxpayers than poor taxpayers. So first of all, a rich taxpayer is the only one, or a relatively rich taxpayer is the only person who's going to think it's worthwhile itemizing. Everyone else is going to take the standard deduction, right? And until 2017 or so, I think something like two-thirds of taxpayers were taking the standard deduction. So right out of the gate, you've got to be pretty well-off to claim this deduction at all, so the benefit only goes to you, [it] doesn't go to those other two-thirds of the people. They don't like that.

The other thing is that a rich person pays tax at a higher rate than a less rich person. So let's say that your marginal tax rate is 50 percent, and my marginal tax rate is 25 percent. If we each deduct $1,000 in state and local taxes, you're going to save $500 on that. I'm only going to save $250 on that because of our tax rates being different. So that makes it, again, regressive, because rich people are getting the real benefit here, and less rich people are getting much less benefit, maybe no benefit at all. So that's why the experts don't like it.

Now, you asked, how is this pitting low-tax states against high-tax states? And I think that's true, obviously, because it subsidizes the government of a high-tax state and all its extra spending. But what's a little complicated about that is that even low-tax states have people who are claiming the SALT deduction. And they tend to be sort of well-off, rich people who are well-connected politically.

So let's say that you are a senator from a low-tax state, the thinking might be, "Ah, you won't care at all about the SALT deduction." Except the guy you're playing golf with at the country club, he cares a lot about the SALT deduction, and that can complicate the politics of this thing. So that red state, we tend to think of this in red state and blue state instead of low-tax, high-tax, but they're interchangeable for this purpose. Those red state representatives, they do sort of care a little bit about the SALT deduction because some of their constituents care too.

So it would be one thing if this fight was like, we had clear battle lines, low-tax, high-tax, red, blue, but in fact it gets kind of messy. There are Republicans, conservatives, whatever, from low-tax states that find themselves in a little bit of a bind because a lot of their fellow conservatives want to get rid of the SALT deduction, but they've got some very well-connected constituents who want to do it. That has proven to be a real problem for the Republicans, especially in, say the last 10 years, but even stretching back to the 1980s. So is it healthy? Probably not, but it's also not as clear-cut as you might imagine.

Robert Goulder: Now, going back a few years to President Trump's first term in office, we had the Tax Cuts and Jobs Act, TCJA, the signature legislative achievement of that term, and it did a lot of things. One of them was it introduced the SALT cap, but it didn't do that in isolation. It happened at the same time that they made a major reform to the standard deduction. Why did they think it was necessary to do both at the same time? I mean, there's a connection there.

Joseph Thorndike: Yeah. Well, I mean, honestly, the biggest reason that they did anything is, again, because the SALT deduction is expensive for the federal government. This subsidy that they're providing to the states costs a lot of money. And so, in 2017, they're trying to put together this big tax reform package, and they need to find ways to pay for it.

Robert Goulder: They need money. They need revenue raisers.

Joseph Thorndike: I mean, it's arguable that we don't pay for a lot of these things anyway, but they're trying to make it look like we're paying for some of it or at least limit the bleeding.

Robert Goulder: The appearance of fiscal responsibility.

Joseph Thorndike: So the SALT deduction is a good place to look in that moment in 2016 when you're putting this all together, because there's a lot of money to be saved there. If we just got rid of it, we would save tons of money. It's one of the biggest tax expenditures for the federal government. So it's on the chopping block, right?

Robert Goulder: Sure.

Joseph Thorndike: Everyone is looking at it. And so, when it comes time to put together this tax reform package and they're looking for revenue raisers, they look there. And the first thing that they do, as you said, they cap it, right? They say, "OK, you can deduct up to $10,000 in state and local taxes that you're paying, but no more." Which is not a lot based on what a lot of people were paying in state and local taxes. If you're rich and you have an income tax in your state, you're paying a lot, a lot more than $10,000.

So that was a big deal to start with. And then the other thing that they did was that they doubled the size of the standard deduction more or less, which made the SALT deduction even less interesting to regular people, because they couldn't reach the threshold. They totaled up all of their stuff, all their possible deductions, and they don't come close to the new standard deduction. So again, it's just like it was in 1944. Every time when you create the standard deduction or when you expand, it's going to reduce the number of people who are taking advantage of any given itemized deduction. So I think that the SALT deduction, it gets claimed by only by about 10 percent, or I think only about 10 percent of people are itemizing after 2017. So it's even —

Robert Goulder: And before it was much more.

Joseph Thorndike: It was about two-thirds.

Robert Goulder: Yeah.

Joseph Thorndike: So that's the big change that happens in 2017. Now, you're going to ask me about the politics.

Robert Goulder: Yes. Because the Democrats didn't like it. Even though arguably it made the tax code more progressive, Democrats didn't like it. In fact, they still don't like it. They saw it very much as the Trump administration punishing blue states.

Joseph Thorndike: So this is a little bit weird, right? The politics are weird. You have a lot of sort-of moderate or even liberal think tanks in DC have not liked the SALT deduction for a long time. The main reason being that it's regressive, that it is worth more to rich people than poor people. And the rich people are increasingly the only ones who can claim it in the first place. So what's good about it, right? If you're a left-leaning policy expert, you don't want tax policies that are only helpful for rich people. So they don't like it. Their friends on Capitol Hill, one of their natural allies, they find that they do like it, because what they say is, "Hey, this is targeting us. This is political targeting, right?" It's like, "It should be a foul in politics, right? That you're coming after the blue states because you think that we need this thing more and that this is a blue state benefit."

And there's some truth to that, that that's the way that many Republicans saw the issue. They were like, "Well, if we're going to have to gore someone's ox, it might as well be those Democrats. And this is important to them and not important to our voters as much." Again, know the politics are complicated, but broadly speaking, "So let's do that." That infuriated a lot of Democrats. The other thing Democrats didn't like about it was that they're doing this to raise money, right? This is to help pay for tax reform. What is that tax reform? Well, generally rate reductions for rich people, for corporations, and they're like, "Ah, this is going to hurt our voters, our taxpayers in our blue state, and you're going to spend all that extra money you raise on cutting taxes for rich people." So that just infuriated Democrats. It was very much a partisan issue, Democrats versus Republicans, and the Republicans are in majority at that point in trying to craft this tax reform bill.

So that's how it really plays out. The problem is the complicated politics. There are a bunch of Republicans representing blue state districts where the SALT deduction matters there, in places like New York and New Jersey. And those sort of pro-SALT Republicans really, really valued the SALT deduction and were not ready to sign on with the rest of their party. Created a big problem in getting that law over the line and it continued to create a problem for years afterwards as they tried to change that cap to sort of restore the SALT deduction to its former glory or infamy.

Robert Goulder: Proof that all politics is local.

Joseph Thorndike: Yes.

Robert Goulder: Especially tax politics.

Joseph Thorndike: Well, and just to point out, a bunch of them lost their elections. Right after the 2017 law passes, there are midterm elections in 2018, and a bunch of those Republicans go down. Now, there's a lot that goes into an electoral defeat, it's not a single issue, but a lot of people took that lesson and said, "Hey, look, if you're a blue state Republican, you cannot afford to get on the wrong side of the SALT."

Robert Goulder: Yeah, this guy raised my taxes.

Joseph Thorndike: Right.

Robert Goulder: Well, speaking of tax raises, I want to ask you a very wonky, inside the beltway question. For a long time in D.C., GOP lawmakers have been encouraged to sign this pledge saying, "I swear allegiance, whatever, I promise I will never vote for any type of tax hike ever of any kind." Did they violate the pledge when they voted for TCJA?

Joseph Thorndike: Well, so here's the thing. Do we want to consider the person, the people who wrote the pledge to be the arbiters of whether or not it has been violated? Because Americans for Tax Reform, which is where this pledge comes from, they say this is not a violation. And their argument is, "The pledge says you can't raise taxes on balance, on net, right? If you raise taxes over here and you cut taxes over here and the cuts are bigger than the increases, you're good to go." That's fine. And so, maybe the terms of that specific pledge, this is not a tax increase, but obviously for some taxpayers, affected taxpayers, it's very much a tax increase.

So I feel like this is one of those things where D.C. inside-the-Beltway politics operates under its own definitions. "Oh, not a tax increase," except for the millions of people for whom it is a tax increase. So I think you can have it both ways. I'm not sure how helpful it is, but as I said, clearly a tax hike for some people.

Robert Goulder: Yeah. And in fairness, the ATR people, they would probably say, "Well, the pledge isn't about all revenue raises." You could still have revenue raises, which is what this is.

Joseph Thorndike: Right, right. Yeah, yeah.

Robert Goulder: That's my question where I'm sort of nitpicking our friends on the right. I want to now nitpick our friends on the left. For all the Democrats who hate this, it does in fact make the tax code more progressive. I mean, is that a valid point?

Joseph Thorndike: I think it is a valid point. And it's why all those left-leaning, liberal-leaning think tanks in town have never liked the SALT deduction or have not liked it for a long time, because they have bought the arguments. And honestly, this expert argument crossed party lines for decades, where people said, "Subsidies like this are not a good idea. If states and localities want to have bigger government, they should just pay for it. So that's not fair to ask. It's not fair to ask people in Mississippi to pay for New York's big government." And they never ever liked the regressivity of it. The fact that it was only claimable by people who were bothering to itemize, which makes them generally speaking, rich in the first place. And because of the way that progressive tax rates work and marginal tax rates work, that deduction is worth much more to a person in a high bracket than it is in a low bracket.

So I think it's definitely a fair point, that it's a regressive benefit. That's made it complicated for Democrats, because on the one hand, they're very committed to making the tax system more progressive. And on the other hand, they're very committed to protecting the people in their own states that are disproportionately benefiting.

Robert Goulder: It's those complicated politics. It makes the whole issue so juicy for taxes.

Joseph Thorndike: Yeah. Right, exactly.

Robert Goulder: It doesn't always align into nice boxes. All right. Fast-forward to last year, 2025, in July we have Congress enacting a major piece of legislation, One Big Beautiful Bill Act, and this tinkered again with the SALT cap. They changed it. And the politics again were peculiar, because even though this was done on reconciliation with Republicans controlling the whole process, you heard different things, different narratives coming out of the House and coming out of the Senate. It seemed like GOP senators really didn't care about raising the SALT cap. They seem to be happy with keeping it low, but not the House.

Joseph Thorndike: Right.

Robert Goulder: Explain that.

Joseph Thorndike: I think that's in the nature of the House and the Senate. So senators are elected at large in their states. There's lots of people. So in a state, a low-tax state like Mississippi, most of their people are not going to care and that's not going to be all that important to a senator's reelection campaign, right? It's sort of diffused among this large population of people who don't really care. The small number of people at the country club, it can be a problem, but you can get over that, right?

It's different for House members, because if you're a Republican House member from New Jersey, you're going to have a focused constituency of people who are the ones who are going to put you in office or take you out of office, and they really care a lot about the SALT deduction. So those guys are not free to toe the party line, right? It's kind of an existential risk for a blue state Republican. And the larger story of American politics is that we've been sorting out our politics more and more completely over time. There aren't really very many blue state Republicans left, but those that are cared a lot about the SALT deduction. All right, so there's only a handful of them, but the House majority for the Republicans, really small.

Robert Goulder: They needed every vote.

Joseph Thorndike: You lose a few of those blue state Republicans on the SALT issue, you lose the whole deal.

Robert Goulder: It doesn't pass.

Joseph Thorndike: You can't get the tax bill across the line.

Robert Goulder: And President Trump was demanding that it be signed. He wanted to sign it, what on July 3 or July 4?

Joseph Thorndike: I think by the 4th of July.

Robert Goulder: So he's setting a time limit and you guys have to pass this. So who won?

Joseph Thorndike: Blue state Republicans propose all sorts of ways to make this SALT cap more tolerable. They want to increase it dramatically to hundreds of thousands of dollars rather than $10,000. And most Republicans are like, "Forget it. Never going to happen." Eventually what happens is that they agree on a significant, but not super dramatic increase in the cap. They raise it to $40,000, which again, that's a big change from $10,000, but it's not life-changing in the way that a $100,000 deduction might be, right? That's a different kind of level, different scale.

So they come up with that $40,000 compromise. They also provide to phase it out. Rich people can't claim that much. And it can actually revert to $10,000 if you have a lot of money. To phase it out for rich people, that makes it a little more tolerable for everyone, including for Democrats. It ends up being just this compromise, which is enough. Enough to get those blue state Republicans to sign on and then get it across the line.

Robert Goulder: I want to wrap up with a question that looks forward. What are the Democrats going to do with the SALT cap? If or when they eventually come to power, I'm going to suggest that that's more of a when than if, at some point there'll be a Democrat in the White House and probably, say at least one of the houses of Congress, if not both. Do they say, "Yeah, we can live with this SALT cap" for the reasons you've just explained? Or they say, "No, no, no. We're in control now. Let's go back to the way the SALT deduction was pre-TCJA?" Can they live with it?

Joseph Thorndike: Like we said, I've been saying the whole time, the politics here are complicated. It's easy to have a lot of clarity when you're not the majority, but when the Democrats had the reins for a little while there, it's not like they went and put the SALT cap back where it was, because they run into that same old problem, which is, it's regressive. And so, are we really going, as we're putting together our own tax bill, like in the early part of the Biden administration, are we really going to expand this deduction, which is essentially spending money when you expand a deduction, you're reducing federal revenues, that's the same as spending money on some level, are we really going to use our fiscal resources to help out these rich people by taking the $10,000 cap and making it a $100,000 cap? It's not really where a lot of Democrats want to go, because it's regressive.

So they did not restore it to its former glory. And I think that going forward, this will continue to be a problem. The conflict between the parties will continue to play a role here. It will continue to seem like a high-tax versus low-tax state issue. It will continue to seem like a blue state, red state issue. But the politics, it's complicated. As we were discussing for the Republicans and even among the Democrats, it's never a clear issue where you should come down. But I think that the regressivity of the SALT deduction will prevent Democrats in all likelihood from sort of resurrecting it or restoring it to what it had once been.

Robert Goulder: Yeah, I think you're right there. Well, that's it, Joe. There you have it. Everything you ever wanted to know about the SALT deduction and the SALT cap. Joe, thank you for your insights about America's fiscal history.

This podcast series is produced by Jordan Parrish. It is edited by Chris Trigo and Carolyn Kuimelis, and Paige Jones is the series' executive producer. Thank you kindly for tuning in and see you next time.