By now you probably know that the 2017 Tax Act significantly limited the deduction of state and local taxes against your federal income. For most Americans -- particularly ones in low-tax states or states with no income taxes -- these new rules will have little effect on your life. For high-income individuals in high-tax states, they will suffer dearly from this policy. There has been speculation of how many will relocate. How bad will the impact be to the states they are leaving? That is another question.
We do not know how many people will leave states like New York, Connecticut or California. We do know that the states they will potentially leave will be severely impacted because the high-earning taxpayers pay a significantly high percentage of the income taxes in these states.
This question hit me square on when I had a chance to interact with a hedge fund operator in a semi-business occasion. He found out I was a CPA specializing in taxes and he immediately launched into a discussion about how the tax law was going to hit him. He is getting hit two ways because his federal income is going to be taxed at higher tax rates due to the new carried interest rules. Also, the voluminous taxes he pays the state of California will no longer be deductible. He told me everyone he knew spent their Christmas break looking for houses in Florida – a no income tax state.
Before you react and say you are not going to have a pity party for these people, you need to think how this is potentially going to change things up. If you live in any of these states, it may well hit your wallet. Maryland instituted a high-earner tax in 2007 and 31,000 high-earner residents left the state costing $1.7 billion in revenue. In my mind many of those people probably had a winter home in Florida already and transferred their principal residence to their pre-established winter home.
Politicians don’t learn from history. Phil Murphy, the newly-installed New Jersey governor, stated one of his initial policies was to soak the rich. This was only 15 days after his high-income residents learned the already high New Jersey taxes were no longer a deduction on their federal returns. Someone needs to inform the new governor that the top 1% in his state already pay 42% of the income taxes. Murphy should also be instructed that New Jersey has the fifth-highest income tax rate in the U.S. and third highest combined income and sales tax rates of the 50 states.
I reviewed the situation for my home state of California, and it is not rosy. For the past few years the top 1% of tax filers pay about 50% of the income taxes each year. Income taxes are 52% of the revenues of the state. As was told to me by the Franchise Tax Board, that 1% constitutes 163,000 tax filers in 2015. Let me assure you they do not have 50% of the income. They did have $320 billion of adjusted gross income and paid California $34 billion in taxes. For those of you who think the wealthy don’t pay taxes, that is an effective rate of 10.4% in income taxes just to California. I would speculate based on 40 years of doing this that their combined effective tax rate for federal and state approaches 50%.
What happens if some of these folks leave? Of course, the elected officials think that will never happen. But if you are living in California and making taxable income of $10,000,000, and you just lost your federal tax deduction of the state taxes of about $1,300,000, you have plenty of incentive - about $481,000. That would pay for a mansion in most states. That is only one year’s savings.
It gets even more tenuous for the tax man. Of those 1% of 163,000, about 70,500 make over $1,000,000 and a mere 25,000 make over $2 million. I could not get a breakdown of what each group paid in taxes, but let’s do some speculation. Let’s say just 10% of this 25,000 leave the state and their average income is $5,000,000. These are reasonable assumptions. Based on these figures the state would lose $1.625 billion in revenue. Since many of these people are job generators, they would take many of their highly-paid staff with them.
Those 2,500 leaving the state would be just a small portion of the people who left Maryland. California has a much larger group of high-earners and the cost of their state taxes just went up an effective 5% by losing their federal deduction. Let me clear here: these taxpayers were paying an effective tax rate of 8.4% under the old system. They are now paying the full 13.3% effective rate. That is a 5% tax raise (4.9%). That is a huge tax raise.
The elected officials of New York and California are spouting schemes to mitigate the negative effects of the new tax law on their residents.These are exactly that – schemes.They have not discussed the only real action that would save them – lower taxes. Right now they cannot because that would mean lower spending. Their governmental structure has the elected officials locked in to fixed payments to their two most important constituencies – government employees and government service recipients.
While elected officials in blue states pitch the same old reasons for maintaining residency in their states, the high-earners are faced with glaring other factors. Here are some facts for California which are not dissimilar in other high-tax states. The unfunded liabilities for the two major pension funds are estimated on the low side at $333 billion and the high side closer to $1 trillion. The inflation rates in large metropolises in 2017 was a full 1.3% higher than the national average driven by local government policies like high minimum wages. Thus, the high cost of living in these cities is getting even higher. And, last, the poverty rate in California is the highest for any state in the Union.
Someone will have to pay for all this. Left-of-center politicians will be aiming at the high-earners, mouthing platitudes of their obligation to pay their fair share. The high-earners will take a harder look at how they are being soaked. These people have not gotten to make the amount of money they do by being stupid. Many of their businesses are more portable today than ever before. They can afford travel to most anywhere they want -- so why stay and be pigeons?
The people who will suffer most are you and me as the government officials will look toward new people to soak to fill their budget holes created by their prior bad decisions. How this plays out will be captivating.