The academic tax law world is abuzz with discussion about how states (or individual taxpayers) may be able to restructure their tax systems in a way that effectively restores the full federal deduction for state and local taxes. For examples, see these two blog posts posts by Daniel Shaviro of NYU law school and this paper by eight tax law professors — Joe Bankman, David Gamage, Jacob Goldin, Daniel Hemel, Darien Shanske, Kirk Stark, Dennis Ventry, and Manoj Viswanathan. As the paper puts it, "it may be possible for states to provide their residents a means of preserving the effects of a state/local tax deduction, at least in part, by granting a charitable tax credit for federally deductible gifts, including gifts to the state or one of its political subdivisions."
I don't, at least yet, have a particularly strong view about whether states or individuals should be able to make this move (if you have a strong view and want to share, the comments are open below.) I do, however, have my doubts about one of the lines of arguments proponents of this tactic are using in its favor.
Professor Hemel (a former colleague of mine at the New York Sun and for sure a brilliant guy) tweeted: "If anything, states that pursue charitable credit strategy are exposing fact that there is no normatively defensible basis for allowing deduction for $$$ —> private schools, private hospitals, etc, while disallowing deduction for $$$ —> public schools, public hospitals, etc."
It seems to me that actually there are bases for distinguishing between the charitable deduction, on one hand, and the state and local tax deduction, on the other hand, even if both fund health and education.
First off, the private/public distinction is a bit of a false dichotomy — you can also already, under current law, claim the charitable tax deduction for funding non-profits that underwrite public health or educational institutions — say, New York City's Fund for Public Schools or Children of Bellevue, a charity that supports pediatric patients at Bellevue Hospital, a New York City public hospital. That won't change under the new tax law.
Second, the difference between charity to education and health causes and state and local tax money to the same causes is that one is voluntary, while the other isn't. With charity, a donor is choosing to give his or her money to fund a cause. With taxes, voters or politicians are compelling — forcing, under penalty of prison for tax evasion — people to give money to fund a cause. It seems to me defensible for Congress to say we want to encourage — not compel, but encourage with a tax deduction — voluntary funding of health and education, but we don't want to encourage compulsory funding of health and education. Congress might think that voluntary giving is a better way to encourage accountability, quality, and efficiency, or that voluntarily funded institutions are less prone to capture by interest groups such as public employee unions. One might disagree with that view, or have a different view of it, but it's a view that it is possible to defend.
Professor Shaviro proposes a kind of middle ground here:
Suppose a state government offers large buckets to which one can charitably designate one's charitable contributions that generate a 100% credit against the tax liability. E.g., Medicaid and Public Health; Schools; Infrastructure, etc. Suppose there were 4 or 5 buckets and that one could get a 100% credit for up to X% of one's state income tax liability by making such designated contributions, but that no more than Y% could go to any one bucket.
The state government would still determine overall annual spending in each category, which wouldn't be directly affected by taxpayers' charitable contribution designations. (NOTE - these contributions probably should be required to be paid separately and prior to the state tax itself - not by designation on the state income tax return.)
So where's the economic substance? Point #1, I get to decide where "my" dollars, as opposed to someone else's, go. Many people actually care about this, as a matter of subjective psychological fact.
But what if the designations to a given category exceed what the state wants to spend on that category? Simple. The state designates those extra $$ as notionally in a "trust fund" that it currently pledges WILL be spent on that budgetary purpose in the future. Consider the analogy to the Social Security Trust Fund. My FICA payroll taxes ostensibly "will" be spent at some point on paying Social Security benefits. Now, budget aficionados may think this doesn't really mean much. But actual voters and taxpayers, and perhaps even the U.S. Congress, actually do think it matters. So who are we to second-guess them? (Especially as they may be correct in the sense of the Trust Fund's affecting likely future political outcomes.)
Hence we get Point #2 for economic substance. My, say, Medicaid-designated contributions WILL, the state now pledges, be spent on Medicaid or other public health either this year in the future. A trust fund pre-commits them to be spent in this way. Sure, the state could change the law next year and take back the promise without recourse on the donor's part. But, just as in the case of the Social Security Trust Fund, the donor gets the benefit of the political force, if any, that the designation might have in the future. Plus, the state legislators are getting what they might deem valuable information about taxpayer sentiment.
That's clever, but it still risks, in my view, blurring the distinction between a private charity and a state or local government, a distinction that Congress, for better or worse, had in mind when it left the tax deduction for one alone but capped the deduction for the other. Maybe a better approach than gaming it would be to just elect enough Senators and Congressmen to restore the state and local tax deduction?
Incidentally, all eight of the law professors who signed that article live in states with income taxes. Six of the eight of them are from California, which has some of the highest state income taxes in the country.