How ending the state and local tax deduction puts Illinois’ economy at a crossroads

Orphe Divounguy

Chief Economist

Orphe Divounguy
October 17, 2017

How ending the state and local tax deduction puts Illinois’ economy at a crossroads

One change in federal tax code – and Illinois lawmakers’ response to it – could decide the economic trajectory of the state.

President Donald Trump has said a key priority for his tax reform plan is to cut taxes for America’s middle-class families.

However, Trump desperately needs to generate enough revenue to finance his proposed tax cuts. And ending the state and local tax, or SALT, deduction is a key component of the president’s original tax reform plan.

The SALT deduction allows households to deduct state and local taxes on their federal returns. A plan to remove the deductibility would disproportionately harm individuals who live in states with a high overall state tax burden, such as Illinois. This is because removing deductibility raises the federal income tax burden by the value of the tax bill due to the state.

In some of Illinois’ counties, the average SALT deduction per tax return is over $5,000 a year, according to the Tax Foundation. But that benefit could vanish if Trump’s tax reform plan comes to pass, costing Illinois households thousands.

An increase in the overall tax burden faced by Illinoisans would have a disastrous impact on Illinois’ economy. This is because an increase in the tax burden further constrains households and businesses, thus discouraging economic activity. In addition, a higher tax burden raises the benefits to be gained from moving toward states with lower tax rates.

Illinois is already experiencing capital flight. According to Internal Revenue Service data, Illinois is already losing higher-earning residents to out-migration. A consequence of these outflows of labor and capital is state tax revenues suffer as the tax base shrinks. This exodus has had disastrous effects on the state’s budget. Eliminating the SALT deduction would only make this trend worse – as the full effect of Illinois’ high state and local taxes is truly felt.

But if state lawmakers pre-empt the possible elimination of the SALT deduction with tax cuts that improve Illinois’ competitiveness relative to other states, the president’s plan can trigger large inflows of capital to Illinois that would grow the state’s economy.

Competitive tax cuts grow the tax base, raising additional public funds without further harm to the average household. As a result, government programs that help the less fortunate can be better funded in a more competitive low-tax regime.

Fiscal solvency is a symptom of tax competitiveness while insolvency – as in Illinois’ current fiscal state – indicates a lack thereof. The bulk of evidence suggests tax hikes shrink the tax base while tax cuts grow the tax base and improve economic conditions for everyone.

Illinois lawmakers concerned about fiscal solvency are at a crossroads. They can adopt competitive tax policies that will curb capital flight, eventually reversing a negative trend at the expense of other high-tax states, or they can do nothing.

If lawmakers do nothing, the elimination of the SALT deduction, if implemented, will result in further erosion of Illinois’ tax base.

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