The new tax code should further hasten the death of the blue state model
Afew years ago, Walter Russell Mead published an insightful article titled, “The Once and Future Liberalism” in which he described two models of governance in the American states. First is the blue state model—found in states like New York, Illinois, and California—which incorporates high levels of public employment, extensive and expensive public services, and high taxes and comprehensive regulations on business. In contrast, the red state model, found in states like Texas, Florida, Indiana, and Tennessee, operates with a lean public sector combined with low taxes and modest regulations designed to promote and attract new businesses. For the most part, Democrats control the “blue” states and Republicans the “red” states.Piereson gives much of the blame for the blue state model to public employee unions who have driven up the cost of government with unsustainable wages and even worse pension benefits that are completely uncoupled from reality. The rich in blue states will pay higher income taxes under the new code because they will not be able to deduct the confiscatory state and local taxes imposed by the blue states to sustain the profligacy.
In Mead’s view, the blue state model is collapsing because voters are rebelling against the high taxes needed to keep it afloat and businesses are fleeing in search of more welcoming tax and regulatory environments. The blue state model, he argues, is a relic of the postwar era when a few companies dominated key industries such as autos, oil, and steel. Back then, U.S. companies faced little international competition, and state and local governments did not worry much about remaining competitive with their peers in the federal system. Those conditions changed beginning in the 1970s and 1980s, when European and Japanese companies entered the American market and citizens began to “vote with their feet” by leaving high-tax jurisdictions.
Now another factor has come into play that will accelerate the demise of the blue state model: tax reform.
The new tax legislation approved this week by Congress and to be signed by President Trump includes a provision that will cap the deduction for state and local taxes (SALT) at $10,000 per household. (Businesses will still be allowed to deduct those taxes as business expenses.) The other provisions of the tax bill—especially the corporate tax rate cut—should encourage investment in the United States and spur faster economic growth. But the cap on state and local deductions may be the most significant in terms of its potential political consequences.
“Boon for the Rich”? Hardly
Up until now, taxpayers could deduct the total expense of state and local taxes from their federal tax bill, a provision in place since the federal income tax originated in 1913. These deductions subsidized high state and local taxes to some degree, or in any case alleviated the burdens of those taxes, especially for wealthy households. The main effect of this provision in the tax law will be to raise the federal tax bill for high income households in blue states like California, New York, Illinois, and Connecticut. The provision will only affect a small share of taxpayers—the 10 or 20 percent that itemize their deductions and previously could claim the full exemption for state and local taxes.
There are also localities within those states, such as Westchester County in New York, Bergen County in New Jersey, and Marin County in California, that impose punishing property taxes to fund local schools and other public services. The vast majority of homeowners in these and similar counties pay far in excess of $10,000 per year in local property taxes. For example, a person owning a $2 million home in any of the above counties probably pays a local property tax bill in excess of $50,000 per year. Wealthy taxpayers in those communities will be hit twice with this new provision as they lose their deductions for state income taxes along with those for local property taxes.
In this sense, the critics are completely wrong who claim that the new tax bill is a “boon for the rich.” It is not: the state and local tax provision seems aimed primarily at wealthy taxpayers.