Trade-offs of Expanding Individual Tax Credits While Repealing SALT Deduction

June 24, 2021

A key theme of our Options for Reforming America’s Tax Code 2.0 is that tax policy is a matter of trade-offs. For example, expanding the generosity of tax credits for lower-income individuals can help make the tax code more progressive, but it also reduces federal revenue. Pairing a credit expansion with a tax offset may sustain federal revenue but can also hamper economic growth.

Take, for example, the option to restructure the Child Tax Credit (CTC) and the Earned Income Tax Credit (EITC) based on a bill introduced by Sen. Mitt Romney (R-UT) this year.

The option would provide an expanded child benefit of $4,200 per child under 6 and $3,000 per child for those ages 6 to 17. It would eliminate the Child Tax Credit’s minimum income requirements and phase out for taxpayers earning more than $200,000 (filing single) or $400,000 (married filing jointly). The Earned Income Tax Credit would also be restructured to provide a maximum credit of $1,000 per adult and an extra $1,000 for households with dependents. In all, it would reduce federal revenue by about $1.4 trillion over 10 years.

One way to offset that cost would be to eliminate the state and local tax (SALT) deduction, which is capped at $10,000 through 2025 and tends to benefit higher-earning households. Repealing the deduction entirely would raise about $1.5 trillion over 10 years—enough to finance the cost of the credit expansion option in the long run, and, on a conventional basis, result in a net revenue gain in the long run.

Revenue Effect of Restructuring the Child Tax Credit (CTC) and Earned Income Tax Credit (EITC) and Eliminating the SALT Deduction (Billions of Dollars)
  2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Total
Repeal State and Local Tax Deduction $32.5 $33.5 $34.1 $35.4 $204.0 $224.7 $234.2 $243.9 $253.5 $267.7 $1,563.6
Restructure the CTC and the EITC -$86.4 -$85.5 -$84.1 -$82.9 -$173.0 -$180.3 -$181.0 -$181.9 -$182.7 -$185.8 -$1,423.6
Total Conventional Revenue -$53.9 -$52.0 -$50.1 -$47.5 $31.0 $44.5 $53.2 $62.0 $70.8 $82.0 $139.9
Total Dynamic Revenue -$59.1 -$58.5 -$57.5 -$55.9 $4.1 $13.6 $19.3 $25.1 $30.4 $38.1 -$100.4

Source: Tax Foundation General Equilibrium Model, April 2021.

Restructuring the individual tax credits and eliminating SALT would also make the tax code more progressive. The after-tax income of the bottom 20 percent of tax filers would rise by 5.5 percent in 2022 on a conventional basis and by 2.7 percent in the long run when including the economic impact.

After-tax incomes would drop for the top 10 percent of tax filers due to the SALT deduction repeal. The top 1 percent would see a 0.2 percent decrease in after-tax income in 2022. After 2025, the current law SALT deduction cap of $10,000 expires, which means that full repeal would reduce the top 1 percent’s after-tax income further to 2.9 percent in 2031.

Distributional Effect of Restructuring the Child Tax Credit (CTC) and Earned Income Tax Credit (EITC) and Eliminating the SALT Deduction (Percent Change in After-tax Income)
Income Quintile Conventional, 2022 Conventional, 2031 Long-Run, Dynamic
0% to 20% +5.5% +3.2% +2.7%
20% to 40% +1.7% +1.7% +1.2%
40% to 60% +1.5% +2.0% +1.5%
60% to 80% +0.8% +0.9% +0.5%
80% to 90% +0.2% -0.2% -0.7%
90% to 95% -0.1% -1.1% -1.6%
95% to 99% -0.3% -2.4% -2.8%
99% to 100% -0.2% -2.9% -3.4%
TOTAL +0.6% -0.2% -0.7%

Source: Tax Foundation General Equilibrium Model, April 2021

Combining the two options would have a negative impact on the U.S. economy. Eliminating the SALT deduction raises marginal tax rates on filers who itemize their income tax returns, which reduces incentives to work and invest. The net effect would reduce long-run GDP by 0.6 percent, eliminate about 404,000 full-time equivalent jobs, and reduce the U.S. capital stock by 0.9 percent.

Economic Effect of Restructuring the Child Tax Credit (CTC) and Earned Income Tax Credit (EITC) and Eliminating the State and Local Tax (SALT) Deduction
Long-run Gross Domestic Product (GDP) -0.6%
Long-run Gross National Product (GNP) -0.5%
Capital Stock -0.9%
Wage Rate -0.3%
Full-Time Equivalent Jobs -404,000

Source: Tax Foundation General Equilibrium Model, April 2021.

While restructuring the Child Tax Credit and Earned Income Tax Credit along with repealing the SALT deduction would raise revenue slightly and make the tax code more progressive, it comes at the trade-off of reduced economic growth. This is a good example of how tax policy changes require making difficult decisions on which trade-offs to prioritize for economic growth, tax distribution, and federal revenue.

Options for Reforming America’s Tax Code 2.0

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A tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.

The state and local tax (SALT) deduction permits taxpayers who itemize when filing federal taxes to deduct certain taxes paid to state and local governments. The Tax Cuts and Jobs Act (TCJA) capped it at $10,000 per year, consisting of property taxes plus state income or sales taxes, but not both.

A tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions.

The federal child tax credit (CTC) is a partially refundable credit that allows low- and moderate-income families to reduce their tax liability dollar-for-dollar by up to $2,000 for each qualifying child. The credit phases out depending on the modified adjusted gross income amounts for single filers or joint filers.

After-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income.

The marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax.

A tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly.

The Earned Income Tax Credit (EITC) is a refundable tax credit targeted at low-income working families. The credit offsets tax liability, the total amount of tax debt owed by an individual, corporation, or other entity to a taxing authority like the Internal Revenue Service (IRS), and can even generate a refund, with earned income credit amounts calculated on the basis of income and number of children.