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States May Shift from Income to Payroll Tax in Wake of Federal Reforms

One of the more controversial changes implemented as part of the recent federal tax overhaul was the institution of a $10,000 cap on state and local tax deductions. As a result of these changes, high-tax states are now looking to find loopholes that will allow them to get around the cap. This may include replacing income taxes with payroll taxes.

By making such a change, states would implement their own payroll tax to be paid by employers, which would then be allowed to deduct those payments. Essentially, this would create a system in which employers pay taxes on behalf of their employees, most likely lowering workers’ pay by the tax amount.

One of the experts who analyzed the ways states could respond to the new income tax deduction caps was Daniel Hernel, an assistant professor of tax law at the University of Chicago. According to Hernel, in a state like Illinois, which imposes a 4.95 percent flat income tax rate, such a system could work like this:

  • In the current system, for any given $100 in wages, $4.95 goes to the state and $95.05 goes to the employee, before federal taxes are applied.
  • In a new system, imagine the state imposes a 5.208 percent payroll tax on employers. The employer would then pay $95.05 to the employee—and that amount times 5.208 percent ($4.95) to the state.

New York among states seriously considering payroll tax solution

The New York Department of Taxation and Finance has already laid out a preliminary play to institute a payroll tax that could help alleviate the burden of income taxes. Governor Andrew Cuomo went so far as to call the proposal a “blueprint” that other state could follow—and that could lead to additional discussions with taxpayers, employers and lawmakers.

This change comes in addition to another proposed tax change, in which homeowners would pay for school taxes as a charitable donation rather than out of their property taxes. This would qualify homeowners to benefit from an additional income tax credit they might not otherwise get under the new federal tax plan.

Cuomo and the state of New York are motivated to make these changes primarily out of a belief that the new tax system harms high-tax states like New York and California. For its part, California is also exploring the payroll tax loophole.

The implementation of these new payroll taxes would be far from a slam dunk. There is still opposition from those who are frustrated at the prospect of an increasingly complicated state tax code, and with the thought of protecting upper-income residents who are more likely to be those who qualify for deductions that fall above the current $10,000 cap.

However, if one high-tax state makes these payroll taxes official, it’s certainly likely more could follow suit.