Many states offer full or partial state tax credits for charitable contributions to or investments in specific types of activities. Common examples include conservation easements and outright donations of land for environmental purposes, scholarship funds that enable students to attend private K-12 schools, donations to public school systems or universities, contributions for neighborhood improvement or economic development, and donation of food to food banks. Historically, most taxpayers have also received a full federal itemized charitable deduction for such contributions, because the state tax credit reduces the taxpayer’s federal deduction for state and local taxes rather than the deduction for charity.4 In the absence of such a deduction, the federal government would essentially be taxing the taxpayer’s state tax credit.
The Tax Cuts and Jobs Act of 2017 limited an individual’s itemized deductions for state and local taxes (SALT) to $10,000 annually ($5,000 for a married individual filing a separate return). In response, several states began developing new tax credit programs to fund state and local functions that would heretofore have been funded through taxation.5 When a state shifts the funding of some state programs from tax revenues to tax credits, taxpayers whose tax liabilities exceed the SALT cap can make donations to the new programs, receive tax credits that reduce their state tax liabilities, and receive a federal charitable deduction for the donation – thus partially or fully circumventing the SALT cap.
The proposed regulation seeks to prevent such behavior by requiring individuals to subtract the value of state or local tax credits from the associated donation in order to calculate the portion of the donation they are permitted to deduct as a charitable contribution. It allows taxpayers to disregard tax credits if they do not exceed 15 percent of the value of the donation, because a tax credit of this size is no greater than a state tax deduction for the donation.6 This comment assesses the regulation and accompanying economic analysis with special emphasis on three key aspects of regulatory analysis outlined in Executive Order 12,866:
Problem analysis: The NPRM identifies a potentially significant problem – state tax credits that circumvent the SALT cap – but provides little evidence demonstrating the size and significance of the problem. Estimates of the potential size of tax credits, federal revenue losses, and efficiency losses due to state SALT workaround schemes would make it easier to determine whether a regulation is necessary.
Alternatives: The regulation is written more broadly than necessary to address the problem the NPRM identifies. Alternative forms of the regulation could tailor the rule to address the fundamental problem while imposing a lower burden on society. A revised final rule should focus on the source of the problem the IRS identifies: state tax credits enacted deliberately to aid taxpayers in avoiding the SALT cap. The charitable deduction should be retained for taxpayers below the SALT cap and for legitimate charitable contributions, even if the taxpayer receives a state tax credit.
Benefits and costs: Several alterations to the assessment of benefits and costs would provide a more accurate picture of the regulation’s likely effects and could prompt different decisions on some aspects of the regulation. The regulation would not only prevent wasteful tax avoidance (which the NPRM discusses), but it would also promote more efficient state and local spending decisions by making each state’s taxpayers bear more of the true cost of those decisions (a benefit the NPRM does not discuss). On the other hand, two claimed benefits of the regulation – increased neutrality between different kinds of charitable donations and increased certainty – are not supported by economic analysis and should be dropped. Finally, instead of simply assuming that the cost of this regulation to taxpayers below the SALT cap is negligible, the IRS should gather empirical evidence and if necessary conduct its own empirical studies to better understand how these taxpayers would change their behavior if they could no longer deduct charitable contributions for which they receive state tax credits.