Retroactive SALT Repeal Combines Weak Stimulus with Bad Tax Policy

Federal Tax

House Speaker Nancy Pelosi (D-CA) has suggested that a retroactive repeal of the cap on State and Local Tax (SALT) deductions should be included in any future stimulus plans. Pelosi’s office has reportedly suggested that this would be tailored towards middle-income households as part of an effort to stimulate the economy.

This is far from the ideal way to stimulate the economy, for several reasons. First, retroactive tax cuts typically have little effect on growth. In general, tax cuts can affect growth in two ways, either on the supply-side or on the demand-side. Supply-side growth effects occur because tax cuts increase the incentive, or the viability, of starting new businesses, increasing capital investment, hiring additional employees or working extra hours.

It’s not impossible for a retroactive tax cut to have a positive supply-side effect but it is difficult to think of how that could occur. Any behavior changes that the tax cuts could have affected would have happened in the past and could not be altered now. Moreover, the SALT deduction has very little, if any, supply-side effect to begin with. So, that makes any supply-side benefit highly implausible.

The second effect is on the demand-side. That comes from giving more money to consumers (or businesses) to use for increased spending. If overall spending in the economy is depressed, then this can have net positive effects on economic growth. This appears to be what Pelosi is after. The problem is that demand-side effects are strongest when tax cuts increase the spending power of households and businesses which are cash-flow constrained. While that could be anyone in the current pandemic, it’s less likely to be the type of affluent households that claim the SALT deduction.

That’s not to say that there would be no effect, just that it is likely to be small from mere reduction in tax liability. A move that increased affluent households’ real estate (or financial asset) values might be big enough to have a major effect. Yet, unless the SALT cap removal is permanent, it’s hard to see how it will affect real estate values going forward.

Lastly, removing the SALT cap has the additional wrinkle of making it politically easier to raise state and local taxes. How much this matters in practice is not clear, but the incentive is certainly there. Again, though, incentive effects are based on what will happen in the future, not what has happened in the past.

All that taken together makes it extremely unlikely that lifting the SALT cap retroactively will have a significant stimulative effect. It is, however, very bad tax policy. First, the SALT deduction reduces the federal tax base, meaning that higher rates are needed to reach any particular revenue target. Second, the benefits of the base reduction accrue almost entirely to higher-income households. Third, retroactively repealing the cap on SALT deductions now increases the pressure to repeal them again later. That increases the potential for those two preceding bad effects to be made permanent.

Yet, because it doesn’t guarantee that the provisions will be permanent, neither local real estate markets nor state and local governments can respond to the potential change in incentives. In this way a retroactive repeal is the worst of both worlds. It increases the probability that bad tax policy will be made permanent without the certainty to even allow the potential side-benefits to real estate markets and state and local governments to materialize.

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