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A few 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.
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.
With the SALT cap in place, governors and legislators in those high tax states will find it more and more difficult to deal with their fiscal problems by raising taxes on wealthy taxpayers and business owners. In the wake of the 2008 financial meltdown, governors in Connecticut, New Jersey, Illinois, and California signed legislation to raise state taxes to deal with financial shortfalls instead of making the more difficult choice to reduce expenditures. This may prove impossible to do in the future, given the incentive that wealthy taxpayers now have to pack up and leave for friendlier tax climates.
To survive in a competitive universe, blue state governors and legislatures may have little choice but to reduce taxes and pare back public services and public employment—in other words, to abandon the blue state model.
The Role of Public Employee Unions
More than anything else, the blue state model was propelled by the creation of robust public employee unions in the 1960s and 1970s—the National Education Association, the American Federation of Teachers, the Service Employees International Union, and the American Federation of State, County, and Municipal Employees. Once these unions won recognition in various states to bargain on behalf of public employees, their members organized politically to push for increased taxes, increased public employment, and higher salaries and pensions.
Many states that adopted income taxes in this era did so due to the political muscle of public unions. As a result, some of these states (Connecticut and Illinois) have had to deal with chronic fiscal crises and public employee pension obligations that cannot be paid absent higher taxes.
Union leaders achieved their political goals by burrowing within the Democratic Party in their states to the point where they eventually gained control of those organizations by providing campaign funds, packing party conventions with union members, and running union-sponsored candidates for public office.
As time passed, the unions were able to use their influence to enact union-friendly policies that always involved higher taxes and more spending on public services. This dynamic relationship among and between the unions, the Democratic Party, and state governments was central to the growth of the blue state model, and to the domination of several of these states by the Democratic Party.
According to the Bureau of Labor Statistics, there are (as of 2016) about 17 million state and local government employees in the United States (about 12 percent of the national workforce) with 6.1 million of them belonging to the various public employee unions mentioned above and another 500,000 being represented by unions (without being union members). Public employee union membership has leveled off in recent years, and there are even signs that it is gradually declining in response to fiscal belt-tightening in many states, along with the effects of “right to work” policies in states such as Wisconsin and Michigan. The BLS shows, for example, a decline from 6.4 million public employee union members in 2012, to 6.3 million in 2013, and 6.1 million in 2016 (the latest year available). In Wisconsin public employee union membership plunged from more than 50 percent of public employees to 30 percent after the state eliminated collective bargaining for public employees in 2011.
The strength of public employee unions is concentrated in a handful of states that, not coincidentally, are controlled by Democrats. In 2014, 13 states had public employee union membership rates exceeding 50 percent of all public employees, led by New York, Rhode Island, New Jersey, Connecticut, Massachusetts, and California with rates greater than 55 percent. All solid blue. Of those 13 states, 11 went for Hillary Clinton in 2016 (Michigan and Alaska were the exceptions).
In general, the movement of those states in a Democratic direction since the 1970s was directly proportional to the growing political strength of their public employee unions. Among 26 states with public employee union membership below 30 percent, 24 of them cast their ballots in favor of Donald Trump in 2016. Most have Republican governors and legislatures.
Capping State Tax Deductions
The cap on the state and local tax deduction will increase the pressure on high-tax states to reduce taxes and rein in spending, and along the way it may curb the power of their public employee unions.
The Government Finance Officers Association reports there were 19 states in 2015 in which the average household deduction for state and local taxes exceeded $10,000. New York, Connecticut, New Jersey, California, and Massachusetts topped the list with the average household deduction exceeding $15,000. In New York, the average household SALT deduction was $22,000. Of those 19 states, nearly all fit the blue state model of high taxes, high spending, strong public employee unions, and Democratic Party control.
Of the 31 states with average deductions of less than $10,000 per household, all but three or four fit the red state model of low taxes, lean public sectors, and a bias toward Republicans. Because taxes are already low, taxpayers in those states would be little affected by the new tax provision.
Within the blue states and across the country, the burden of the new provision will fall mostly on wealthier households in the top 10 percent of the income distribution.
According to GFOA study, the average SALT deduction for households reporting less than $100,000 in income was around $4,000—meaning that very few of those households will be affected by the provision. On the other hand, households reporting incomes between $200,000 and $500,000 had average SALT deductions of $23,000 and those with incomes exceeding $1 million had average SALT deductions of $274,000. Those in this latter bracket may see an average increase of $100,000 or more in their federal tax bill.
From a national point of view, the new provision will mostly affect high-income households, most of them reporting incomes in excess of $200,000 per year. But a high proportion of those households are situated in the high-tax jurisdictions, and many of them in towns and counties with high property taxes.
High Taxes Should Be Paid by Those Who Vote for Them
When the implications of the new provision hit home, those high-income taxpayers and business owners will either think about leaving for more welcoming jurisdictions or they will begin to pressure state and local officials to reduce their tax and regulatory burdens.
The problem for the high-tax states is that they have burdensome legacy costs in the form of built-in civil service protections for public employees and pension and health care obligations for employees that cannot easily be reduced. Some states, such as Illinois and Connecticut, are already feeling the pinch of high legacy expenses combined with sluggish economic growth. As the new provision kicks in the vise will tighten on these and other blue states where political pressures drive taxes and spending higher at a time when federal tax policy is suddenly pushing them in the opposite direction.
Blue state governors view the new SALT deduction limits as a calamity—and understandably so. All of them were elected to represent public employee unions and the major recipients of public spending. The governors of New York, California, and Connecticut, along with the mayors of New York City and Chicago, have spoken out forcefully against the provision. Now that the bill is law they will have little choice but to reckon with its consequences, which are likely to be significant.
But from another perspective, the tax reforms are an opportunity to reorder the political dynamic in blue states where public-employee unions have outsized influence on taxing and spending, and ordinary citizens have little recourse except to move elsewhere.
As blue state leaders adjust their policies, their states will gradually become more competitive with their peers in the federal system. At the same time, such policies, difficult as they may be to accept, will salve the inflamed relations among the blue and red states and perhaps help to heal the divide that now threatens to tear the country apart—something that can only be good for America.