Democrats in High-Tax States Plot to Blunt Impact of New Tax Law

Democrats in high-cost, high-tax states are plotting ways to do what their states’ representatives in Congress could not: Blunt the effect of the newly passed Republican tax overhaul.

Governors and legislative leaders in New York, California and other states are considering legal challenges to elements of the law that they say unfairly single out parts of the country. They are looking at ways of raising revenue that are not penalized by the new law. And they are considering changing their state tax codes to allow residents to take advantage of other federal tax breaks — in effect, restoring deductions that the tax law scaled back.

One proposal would replace state income taxes, which are no longer fully deductible under the new law, with payroll taxes on employers, which are deductible. Another idea would be to allow residents to replace their state income tax payments with tax-deductible charitable contributions to their state governments.

Such ideas may sound far-fetched. And until recently, they were mostly the province of tax professors and bloggers. But they are now getting serious consideration in state capitols where some lawmakers see the Republican law as a thinly veiled assault on parts of the country that typically vote for Democrats.

Companies, of course, have long sought to exploit loopholes in the tax code. Governments, as a rule, have not. State leaders, however, said Congress, in singling out certain states, had broken an implicit compact with the states.

“The game has changed,” said state Sen. Stephen M. Sweeney, the Democratic president of New Jersey’s Senate. “They’ve completely turned the tables against us.”

In particular, officials in the high-tax states object to the law’s $10,000 cap on state and local tax deductions, which were previously unlimited. That provision will be particularly painful for residents of states like New York, New Jersey, California and Connecticut, which have high housing costs and high tax rates.

Even in those states, 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.

The law could also have broader economic consequences. Business leaders, for example, have said they worry about attracting workers if New York and other cities become even more expensive than lower-tax areas.

State leaders are still figuring out their response to the new law, and few have yet endorsed specific proposals. But they are moving quickly. Gov. Andrew M. Cuomo of New York, a Democrat, recently said he expected to provide a more detailed plan when he presented his state budget in mid-January.

“They want to target us for certain provisions?” Cuomo asked at a recent news conference. “Well, let’s see if we can redesign our tax code to get out of the federal trap that they set.”

Cuomo fired one of the first shots when he signed an executive order that let New Yorkers prepay their 2018 property taxes in 2017, before the new deduction cap takes effect. Several other state and local governments followed suit.

But in an indication of the hard road ahead for Democrats, the Internal Revenue Service issued guidance Wednesday limiting the prepayment option. And the option was only a temporary reprieve — at best, homeowners could delay the effect by a single year.

State leaders are looking for longer-term solutions. Some have raised the possibility of shifting away from taxes on individuals toward taxes on corporations, which are still fully deductible under federal law. But that could cause its own problems: Raising taxes on businesses could make it harder for those states to compete for companies and jobs.

Other lawmakers have floated the idea of seeking out new sources of revenue, perhaps by legalizing — and taxing — marijuana.

Some proposals are more complex. Kirk Stark, a law professor at the University of California, Los Angeles, has suggested that states encourage residents to donate money to their state governments, then let the governments credit those donations against their state income taxes. Such donations would qualify as charitable donations, which are still fully deductible on federal taxes.

Stark noted that such programs existed, albeit in a much more limited form. Several states let residents count donations to private schools as state tax payments under certain circumstances, an initiative that conservatives have promoted as a step toward school vouchers.

Another idea would be for states to partly or completely replace their income taxes with payroll taxes paid by employers, similar to taxes for Social Security and unemployment insurance.

In theory, such a move would not change after-tax income for either companies or individuals. It would just change where the tax checks were coming from. Companies would reduce workers’ pay by the amount of the payroll tax, and would be able to deduct the payments on their federal taxes. Because they would never receive the money, workers would not be taxed on it.

“In effect, it preserves the state income tax deduction,” said Dean Baker, a liberal economist who has been pushing for the plan.

Both ideas — and others like them — would face logistical hurdles, legal challenges and, most likely, opposition from Congress and the federal government. But they are nonetheless rapidly moving from the realm of academic theory into actual policymaking. State Sen. Kevin de León, a Democrat who is president pro tem of the California Senate, has announced plans to introduce legislation aimed at reducing the effect of the tax law. He is consulting with Stark, among others, to develop the legislation.

De León and other legislators concede that they are trying to game the system. But they argue that Congress left them little choice.

“This is highly unusual tax policymaking,” said de León, who has announced plans to run for the U.S. Senate next year. “However, this is a highly unusual time in the history of this country.”

Republicans argue there is a much simpler solution for high-tax states: Lower their taxes.

State Sen. Joseph Pennacchio, a Republican state senator in New Jersey, said he opposed limiting the state and local tax deduction but New Jersey should focus less on gaming the system and more on lowering its tax burden.

There are signs that may be happening. Sweeney, the Senate president, said that because of the new tax law, he had “pressed the pause button” on a plan to impose a new tax on millionaires.

“Maybe people are starting to realize,” Pennacchio said, “you’ve got to tiptoe when it comes to raising taxes, because it can do more harm than good.”

Still, lawmakers from both parties said it would be hard to cut taxes enough to offset the effect of the new tax law. For one thing, states like New Jersey and New York have high costs of living and high housing costs, not just high tax rates. Even if their tax rates were the same, far more homeowners in New Jersey than in Alabama would hit the $10,000 cap.

But perhaps more significant, cutting taxes would also mean cutting funding for schools, subway systems, anti-poverty programs and other services that residents in those states have come to expect.

“I suppose the rational response for us is to lower our taxes,” said Benjamin Barnes, who heads the Connecticut Office of Policy and Management, “but we have a public that has shown again and again that they expect high levels of service.”

Philip D. Murphy, a Democrat who will be sworn in as governor of New Jersey in January, has said his administration might challenge the law on constitutional grounds. Democrats in other states have made similar suggestions.

Legal scholars said states could try to argue that the law treated certain states unfairly. They might also argue that the 16th Amendment, which authorized the federal income tax, meant to define “income” as income after state taxes had been paid, essentially enshrining the state and local tax deduction in the Constitution. Few scholars, however, think such arguments have much chance of success. And Daniel Hemel, a law professor at the University of Chicago, said Democrats should think twice before making them.

“The Democratic Party’s long-term agenda requires the federal government being able to raise revenue,” Hemel said. “This would be short-termism at its worst, potentially setting back the progressive agenda for decades to come in response to a bad tax bill.”

Then, there are some state leaders who say the best way to fight the new law is neither through legal challenges nor through complex changes to tax codes.

“Our first line of defense,” Barnes, the Connecticut official, said, “is to take back Congress for Democrats.”