Four States File Lawsuit Against Trump Administration Over Tax Deduction Changes

Four states filed a lawsuit against the U.S. Treasury Department and IRS Tuesday, arguing the new $10,000 cap on the federal tax deduction for state and local taxes interferes with their abilities to make policy choices about what government provides in their communities.

The change to the so-called "SALT" deduction was one of the most contentious provisions in last year's Republican tax cut bill. It essentially raises taxes on many residents of states with high state and local taxes, as taxpayers previously were allowed to deduct all or much of those taxes as they did their federal taxes.

Earlier this year, New York Gov. Andrew Cuomo said the lawsuit was coming, while his state and others also worked on other legislation to try to get around the federal tax change.

New York Attorney General Barbara Underwood filed the lawsuit in federal court on behalf of her state, along with the attorneys general of Connecticut, Maryland and New Jersey.

The deduction has been a target on Capitol Hill in the past, but has always been preserved until 2017, when the limits were imposed. In fact, the lawsuit notes the deduction has been in place since 1861, while arguing the full deduction is necessary so that the federal government can't essentially dictate state tax policy by usurping their tax resources.

During debate about the tax cuts, Democrats complained that capping the deduction unfairly targeted "blue" states. For example, the Tax Policy Center found that the average amount claimed in Connecticut was almost $20,000 and more than $22,000 in New York. In comparison, the average amount claimed between 1997 and 2015 in Texas was about $7,800.

“This is their political attempt to hurt Democratic states,” Cuomo said in a call with reporters. “It is totally repugnant and hypocritical of the fundamental conservative ideology which they preach—the limited federal government, respect state rights.”

New York asserts that state taxpayers will pay $14.3 billion more in federal taxes in 2018, according to a news release. The lawsuit also targets the partisan nature of the debate about the SALT deduction, emphasizing some comments by Republicans about how affected states might need to make different policy decisions.

But during negotiations, advocates were able to get concessions, as some initial versions called for totally axing the deduction. Treasury Secretary Steven Mnuchin is named as a defendant in the lawsuit, along with the IRS Commissioner David Kautter and their agencies.

A Treasury spokeswoman said the agency is reviewing the complaint.

But since several states announced their intention to sue earlier this year, some have been skeptical of the tactic and arguments that the capping of the deduction unfairly hurts certain states.

Jared Walczak, a senior policy analyst at the Tax Foundation, a conservative-leaning tax policy group, noted in January that the tax deduction benefits wealthier taxpayers. And he said that both tax policy and federal budget expenditures often affect states and regions differently, but lawsuits aren’t necessarily filed. Plus, many taxpayers hit by the SALT deduction cap will get the benefit of lower federal taxes.

“These states’ high earners already get the benefit of lower rates and broader bracket widths,” he wrote in a blog piece.

The lawsuit cites argues that the U.S. Constitution's 10th Amendment, which grants powers to the states and limits the federal government's power to impose on them, should be in play in this situation. This is because limiting the longtime deduction “interferes” with their ability to guide their own fiscal policies, the lawsuit says.

“By reducing the wealth of taxpayers in the Plaintiff States and undermining the States’ revenue sources, the new cap on the SALT deductions will ultimately make it more difficult for the States to maintain their current taxation and fiscal policies, and deprive the Plaintiff States of the ability to raise revenue in the future,” the lawsuit maintains.

But Joseph Bishop-Henchman and Jennifer Hill with the Tax Foundation in April argued a 10th Amendment approach in New York’s then-anticipated lawsuit didn’t make sense, as the states weren’t being forced to adopt policies by the federal government.

“The states may argue that because the cap reduces a tax benefit currently enjoyed by some residents of states that generally have higher taxes, there may be implicit pressure on policymakers in those states to reduce state taxes,” they wrote. “This pressure, however, is not so large as to deprive state policymakers of any choice in the matter, as demonstrated by the wide variety of state actions in its wake and the lack of any specific direction by Congress on how states should conform to the new federal tax code.”

The lawsuit also references the 16th Amendment, which gives Congress the power to collect taxes, saying that when it was ratified in 1913 "it was widely understood that, to the extent the federal government taxed income, it would provide a deduction for all or a significant portion of state and local taxes."

Several of the states in the lawsuit—New York, New Jersey and Connecticut—passed legislation this year aimed at getting around the federal deduction cap. For example, New Jersey’s law would allow local governments and taxing districts to set up charitable accounts that would pay for services usually funded by property taxes. Taxpayers would then be eligible to deduct those charitable contributions, according to the Newark Star-Ledger.

But it is unclear whether the IRS will let these “workaround” tax schemes move forward. In May, the agency issued a notice that it will come up with guidance about the measures. That guidance has not yet appeared.