The Justification for Income Tax Deductions
Current federal tax law permits businesses to deduct expenses they incur from producing goods and services from their income. For example, a business can deduct the wages and salaries paid to its employees because these employees will pay taxes on their own incomes. This deduction helps avoid the double taxation of those employee incomes. Businesses can also take a deduction for equipment and material they buy from other businesses and use in making their own products. Those suppliers will pay income taxes on their own sales. These deductions make an enormous difference to a business’s taxable income. For example, businesses that file their taxes as corporations had a total of $33.4 trillion in receipts in 2020. Allowable deductions amounted to $31.2 trillion. Thus, corporations had a net income (after adjustments for foreign income earned) of about $2.8 trillion (or 8.4 percent of total receipts).
There are several deductions, however, that have nothing to do with avoiding double taxation. For example, Congress has a long-standing policy of allowing taxpayers (including businesses) to deduct their contributions to recognized charitable organizations. This allowance stems from a public policy of supporting charitable activity. Congress also allows businesses to deduct their bad debts. Carrying uncollectable liabilities on a business’s books likely reduces a firm’s ability to obtain low-cost credit, and that may inhibit another of Congress’s enduring policies: optimal economic growth.
The Deduction for State and Local Taxes
There is also a deduction for taxes paid to state and local governments. This deduction, frequently called by its acronym SALT, allows a qualifying business to subtract taxes it pays to inferior U.S. governments (like state and local governments). However, what justifies this deduction? Unlike the social and economic objectives of many other deductions, this path to reducing taxable income seems out of place. However, it’s seeming oddity stems from its origins in a wholly different part of the public policy spectrum: the relationship between taxing authorities in a federal system of government.
Our constitutional, republican system of government is founded on sovereign citizens first establishing local and then larger governments to provide public goods and public safety. Because income in the form of revenues is vital for the effectiveness of these governments, a practice began from the beginning of the Republic of superior governments recognizing the revenue sources of inferior governments and either avoiding those sources for their own income needs or allowing taxpayers a deduction for taxes paid to inferior governments. Such was the case during the Civil War when the federal government imposed the nation’s first and short-lived corporate profits tax and allowed corporations to deduct state and local tax payments. That deduction was allowed again when the corporate profits tax was revived in 1910 in the so-called Aldrich Tariff and a few years later when the current corporate profits tax was created following adoption of the 16th Amendment to the U.S. Constitution (1913). Thus, this deduction, while seemingly out of place in a current income tax code filled with a wide array of social and economic provisions, most likely has one of the deepest and best-established pedigree of any public policy deduction in the code.
At the same time, that pedigree does not exempt the deduction from criticism. Some argue that the deduction reduces the taxpayer’s cost of paying state and local taxes. Thus, states may raise their tax rates knowing that the taxpayer can deduct those state tax payments when they pay their federal taxes. For example, if a taxpayer has a federal tax rate of 20 percent, then a $1,000 state tax payment gets lowered effectively to $800 when the taxpayer receives a $200 reduction in federal taxable income through the SALT deduction. The incentive, then, for state and local governments is to raise taxes more than they would if no federal SALT deduction existed.
Congress moved to limit the SALT deduction for individuals in the Tax Cuts and Jobs Act of 2017 (TCJA), but that raised another objection to SALT. By limiting the deduction to $10,000 for individuals, millions of businesses that file their business taxes on the individual tax form (see EPIC’s earlier Explainer on pass-through taxation) are now at a disadvantage compared to many types of corporate businesses that have no limitation on the SALT deduction. Thus, should a corporation have access to uncapped SALT deductions while pass-through businesses do not? This uncapped deduction changed for the very largest corporations when the Inflation Reduction Act of 2022 introduced the Corporate Alternative Minimum Tax. The AMT effectively blocked access to many deductions, including corporate SALT, for corporations with financial statement income above $1 billion. However, the uncapped SALT deduction remains for the over 5 million corporations with income below that level.
Thus, using the SALT deduction remains a major feature of a typical corporation’s tax strategy. The total amount of SALT deductions by corporations in 2020 (the latest data year from the IRS) equaled $593.4 billion. Thus, it is a significant contribution to lowering a business’s tax liabilities. About 70 percent of all businesses able to use the corporate SALT deduction were corporations filing on Form 1120, so-called C Filers. If one multiplies their SALT deductions by the corporate tax rate, the gross reduction in taxes from SALT for C corporations equaled $87.2 billion in 2020. Given that C corporations paid $276.6 billion in 2020 federal taxes, this deduction likely played a major role in lowering corporate liabilities, even after all the other adjustments made before final payments were determined.
House and Senate policy makers will once again consider the fate of the SALT deduction when they debate the extension of TCJA in 2025. Many of the key provisions, including the limitation on individual SALT deductions, will expire at the end of that year. Some policy makers would like to extend that limitation and apply it, as well, to the corporate SALT deduction. Others want to eliminate any limitation on the deductibility of state and local taxes. Either way, this long-standing feature of U.S. revenue policy and tax law will once again be front and center in tax policy debates.
