Trump’s Blue State Revival Plan

Schumer’s choice: Play on tax reform or lose the state and local deduction.

Senate Minority Leader Chuck Schumer answers questions during a press conference at the U.S. Capitol, May 23. PHOTO: GETTY IMAGES

Chuck Schumer aspires to raise taxes on every rich person in America, save one protected class: coastal progressives. The Senate Minority Leader recently styled part of President Trump’s tax plan as “a dagger aimed at the heart” of New Yorkers. Like many other Democrats, he’s apoplectic about a plan to end the state and local tax deduction.

Taxpayers who itemize—about one in three do so—can deduct income and property taxes paid to state and local governments from their federal tax liability. The White House in its recent tax outline proposes eliminating the deduction, and the House blueprint does as well.

One goal of tax reform is to reduce unproductive tax loopholes, and ending the state and local deduction would generate revenue to finance lower rates: The deduction is worth about $100 billion a year—the sixth largest individual income tax break. The Tax Foundation estimates that eliminating the write-off would raise $1.8 trillion in revenue over a decade.

While Democrats like to soak the affluent, they make an exception for the state and local deduction: About 88% of the benefits in 2014 flowed to taxpayers who earn more than $100,000, while 1% went to those who earn less than $50,000. California alone reaps nearly 20% of the benefit, according to the Tax Foundation, and a mere six states get more than half. (See table)

Even those figures don’t capture the saturation. The average deduction in New York County, N.Y., i.e., Manhattan, is a few bucks shy of $25,000. The top 10 counties are in four states, including San Francisco County, Calif. ($12,116) and Morris County, N.J. ($11,440). The folks underwriting this windfall are in Alaska, South Dakota, Wyoming and other places without a state income tax. Those filers pay more to make up for what the federal government leaves on the table to help high-tax states.

Note that New York and California, which are home to top income-tax rates above 12%, have been run by progressives for decades. Which brings us to the left’s real objection: The deduction underwrites spending and punitive taxes that would be harder to sustain politically without the generous federal write-off.

Eliminating the deduction would be a powerful incentive for Governors to cut state taxes on residents who are suddenly exposed to their full liability. This is not a punishment for progressive locales but a revival project for Democratic states. Tens of thousands of Northeasterners have fled to Florida, and Connecticut Governor Dannel Malloy is all but personally negotiating with residents on what subsidies, loan forgiveness or other handouts will keep them from leaving his state. (See below for the Hartford follies.)

Eventually that tax-base erosion will sink public pensions and other unfunded liabilities. Removing the deduction would force Mr. Malloy and his counterparts either to cut taxes or watch the notices to vacate continue. At a minimum, killing the subsidy would increase the political cost of blithely raising taxes.

Some will say that the deduction merely avoids double taxation on the same income, but a March primer from the Tax Foundation exposes this argument as shallow: Residents pay for different services—say, trash disposal from local government and national defense from the feds—so one would expect these items to be funded separately. Perhaps states and cities would rely more on arrangements like user fees that bring the price of a service much closer to its cost.

The political resistance to killing the state and local deduction will be fierce, and even Ronald Reagan in 1986 could not muscle a plan through Congress that eliminated it. But in 1986 Democrats like Bill Bradley and Dan Rostenkowski were willing to negotiate over reform. With a hand in the game they had policy leverage.

As our friend Donald Luskin has pointed out, the Schumer Democrats have no standing to stop Republicans from eliminating the blue state tax benefit if they sit out the debate. The GOP only has an incentive to deal if Mr. Schumer delivers at least eight Democrats to provide the 60 votes to make tax reform permanent under Senate budget rules. What will it be, Chuck, play or have your constituents pay?

As tax policy, meanwhile, killing the state and local deduction would pay a double dividend: The first is creating a more equitable tax code with a broader base and lower rates. The second is spurring reform in states that are long overdue for a better tax climate.

Connecticut’s Tax Comeuppance

With the rich tapped out, the state may resort to Puerto Rico bonds.

Connecticut Gov. Dannel P. Malloy at the state Capitol in Hartford, Feb. 8. PHOTO: ASSOCIATED PRESS

The Aetna insurance company has been based in Hartford, Conn., since 1853, but this week it said it is looking to move to another state. Governor Dannel Malloy (D) has pledged to match other states’ financial incentives, but taxpayer money can’t buy fiscal certainty and a less destructive business climate. That’s the real problem in Connecticut, which saw GE vamoose to Boston last year and which even Mr. Malloy now seems to recognize.

“As a huge Connecticut employer and a pillar of the insurance industry, it must be infuriating to feel like you must fight your home state policymakers who seem blind to the future,” Mr. Malloy wrote in a May 15 letter to Aetna CEO Mark Bertolini. “The lack of respect afforded Aetna as an important and innovative economic engine of Connecticut bewilders me.”

Now he tells us. Gov. Malloy has spent two terms treating business as a bottomless well of cash to redistribute to public unions. Now that his state is losing millionaires and businesses, he has seen the light. But the price of his dereliction will be steep.

Last month the state Office of Fiscal Analysis reduced its two-year revenue forecast by $1.46 billion. Since January the agency has downgraded income-tax revenue for 2017 and 2018 by $1.1 billion (6%). Sales- and corporate-tax revenue are projected to fall by $385 million (9%) and $67 million (7%), respectively, this year. Pension contributions, which have doubled since 2010, will increase by a third over the next two years. The result: a $5.1 billion deficit and three recent credit downgrades.

According to the fiscal analyst, income-tax collections declined this year for the first time since the recession due to lower earnings at the top. Many wealthy residents decamped for lower-tax states after Mr. Malloy and his Republican predecessor Jodi Rell raised the top individual rate on more than $500,000 of income to 6.99% from 5%. In the past five years 27,400 Connecticut residents, including Ms. Rell, have moved to no-income-tax Florida, and seven of the state’s eight counties have lost population since 2010. Population flight has depressed economic growth—Connecticut’s real GDP has shrunk by 0.1% since 2010—as well as home values and sales-tax revenues.

Corporate revenues also took a hit after General Electric relocated to Boston. Mr. Malloy then offered tax breaks to hedge funds and companies to stay in Connecticut, which has further eroded revenue.

The Governor—a slow learner—seems finally to have accepted that raising taxes on the wealthy is a dead fiscal end. Democrats are now proposing higher taxes on tobacco, expanding casinos and eliminating some tax breaks, though they don’t want to touch an exemption for teacher pensions. The state teachers union warns that axing the exemption would impel retired teachers to relocate. A quarter of pension checks are currently sent out of state.

Mr. Malloy is also seeking $1.6 billion in concessions from unions, which would be easier to achieve if collective bargaining weren’t mandated by law. He’s suggested increasing municipal pension contributions and cutting state-revenue sharing, both of which could drive up property taxes and imperil insolvent cities like Hartford. Mr. Malloy’s budget includes a $50 million bailout for Hartford to prevent bankruptcy, which might occur in any case if Aetna—its fourth largest taxpayer—leaves.

The state treasurer has advocated “credit bonds” securitized by income-tax revenues to reduce the state’s borrowing costs. Investors beware: Puerto Rico tried something similar with its sales tax, and bondholders might not get back a penny. Maybe Democrats should follow Jerry Seinfeld’s advice to George Costanza and do the opposite of the instinct that has brought the state so low: Cut taxes.