Will "soak the rich" make Democratic states feel blue? By Scott Sumner

In the 2018 midterms, my congressional district in southern Orange County elected a Democrat named Katie Porter. Although she is quite progressive, she strongly opposes the new cap on deductions state and local taxes (SALT). Southern Orange County is mostly upper middle class, and this tax change hits our area harder than many other parts of the US.

Nonetheless, the cap on SALT deductions is a progressive provision in the tax code, with the higher tax burden falling overwhelmingly on the top quintile. It also makes the tax code more efficient. As an aside, this was part of a GOP bill that also cut tax rates for affluent taxpayers. So the net effect of the tax bill was probably positive for my district. It was certainly positive for me, and I’m a fairly typical resident.

At the national level, the Democrats are moving in a “soak the rich” direction, with both Sanders and (frontrunner) Warren proposing wealth taxes for the rich. But how do the blue states feel about these ideas?

It’s worth noting that of the 16 states with the fewest millionaires per capita, all but New Mexico voted for Trump. Of the 14 states with the most millionaires per capita, only Alaska and New Hampshire voted for Trump. Rich states tend to be blue states. So one might expect even Democrats to be reluctant to soak the rich if it means soaking their constituents.

[And even these figures may understate the pattern, as my source excludes real estate wealth. Many of the rich blue states have very expensive homes.]

On the other hand, the $10,000 SALT cap hits a substantial number of voters, whereas some of the recent wealth tax proposals would impact only a small number of individuals. Might the Democrats be willing to support taxes that hit their states disproportionately, but impact only a tiny number of voters?

Actually, even progressive politicians can become quite protective of the super-rich when they look at things from a local perspective. Wealthy residents in places like Manhattan and Silicon Valley provide a hugely disproportionate share of revenues to state governments. These governments may have progressive instincts, but they don’t want to “kill the goose that lays the golden eggs”.

Assume that you are a progressive that wants to set an revenue maximizing income tax rate on people making over $1,000,000/year. You seek the “top of the Laffer Curve” tax rate. Now suppose that you estimate 8% to be the optimal rate. You believe that at higher rates the tax becomes counterproductive. In that case, as long as state and local taxes are fully deductible, you might set the top rate at about 13%, as California did a few years ago. At that rate, the effective rate on the rich was roughly 8%. But with the recent $10,000 cap on SALT deductions the marginal rate on the rich in California effectively jumped from about 8% to 13%.

It might seem odd to suggest that a rate as low as 8% is the revenue maximizing rate for a state government. But you need to consider several factors:

1. Laffer Curve effects are much more powerful at the state level than at the national level, as people can easily move between states. Yes, the maximizing rate will be higher in states like California, New York and Hawaii, which have amenities that tend to hold the rich in place. But there is still a limit.

2. The state tax is added to the federal income tax rate, which maxes out in the low 40s. (It’s complicated)

3. You need to also think about indirect effects. The loss of a single extremely rich taxpayer may have indirect effects as well, if the owner of a company brings their firm with them when they relocate from Silicon Valley to Austin, or New York to Miami.

4. And of course you need to consider long run effects. People don’t move immediately, but fewer new businesses may be set up in your state.

I’m certainly not claiming that I know for certain that California’s 13% tax rate is now counterproductive. But wherever the revenue maximizing rate is, it’s substantially lower after the SALT cap was imposed. Thus if it were 20% before, then it’s closer to 13% now. Blue state reps have a strong incentive to prevent the federal government from encroaching on their state’s tax base.

I tend to doubt that a blue state dominated political party will be able to get a “soak the rich” tax regime through Congress, even in the unlikely event the Democrats take control of the Senate.

“All politics is local”.