SALT decision looms over falling state tax revenues

The budget reconciliation battle over the cap on state and local tax deductions moves to a close as state tax revenues show gains from personal income tax but declines in corporate and sales tax inflows.

"The fiscal outlook for most states remains bleak, as tax revenue growth continued to lag in the first half of fiscal year 2025," said Lucy Dadayan, principal research associate at the Tax Policy Center, Urban Institute & Brookings Institution.

"This sluggish performance is partly attributable to widespread tax rate reductions and other relief measures enacted in recent years."

The comments come in conjunction with a finely-detailed, 40-page report laying out tax trends, their effect on state budgets in the first half of 2025 and what could happen if and when the cap on state and local tax deductions cuts are lifted.

The SALT deduction was capped in 2017 as part of the Tax Cuts and Jobs Act. The provision remains unpopular in states with high tax rates and the muni community who believe it limits local taxing flexibility.

SALT has been causing controversy since it was enacted as thirty-five states and New York City have created legal workarounds, known as Pass Through Exemptions.

PTEs allow business owners to receive their income through their businesses which triggers a state tax credit which helps offset the cap.

According to The Tax Foundation, a non-partisan think tank, eliminating the pass-through entity exemptions would raise $200 billion over ten years.

According to Dadayan, raising the deduction cap will nullify the credits.

"If the SALT cap is raised to $30,000 or even $40,000, as some blue state Republicans have proposed, PTE tax elections likely won't disappear, but they will become less appealing and more limited in scope," she said.

"The proposed legislation includes specific limitations on PTEs and introduces new compliance requirements that could reduce their usefulness."

While the PTEs provide relief from federal taxes, their effect on states budgets is perceived to be minimal if the cap gets lifted.

"In general, state tax revenues likely wouldn't be significantly affected," said Dadayan. "PTE taxes are designed to be revenue neutral."

"Even if the SALT cap is lifted, some taxpayers may still opt for the entity-level tax if it offers a specific federal tax benefit in their situation."

State taxes and their resulting revenues have been affected by flattening rate trends, rebates, swollen reserves, and rate cuts as the report shows a mixed bag of early outcomes for 2025.

"State and local tax revenue performance weakened in the fourth quarter of 2024, with all major sources combined increasing by 0.1 percent in real terms compared with the same period a year earlier," writes Dadayan.

"While local tax revenues posted modest real growth, major state tax revenues declined, reflecting the ongoing volatility in key state revenue streams."

The report also includes major caveats for what's coming down the pike for state budgets in addition to tax policy turmoil.

"New federal policies?such as tariffs, funding reductions, and federal workforce cuts?are already impacting state economies by raising costs, dampening consumer spending, and increasing pressure on budgets," writes Dadayan.