The recently enacted restriction of federal deductions for state and local taxes (SALT) to $10,000 (including local property and sales taxes, as well as local income taxes) will have an especially large impact on states that have large unfunded liabilities for pension benefits and retiree health care, according to Brookings.
"Unless states can implement effective ways to circumvent the SALT restriction, they will face much higher political barriers to meeting their unfunded benefit obligations through increased tax revenues," Brookings reports. "Instead, states will be forced to severely cut spending on public services and/or adopt major reforms of their benefit plans."
A state has payment obligations from three main sources: interest on its outstanding bonds, unfunded liabilities for pension benefits, and unfunded liabilities for health-care payments to state retirees (before Medicare at age 65).
Large increases in state revenues are not feasible. The State of Illinois, for example, has attempted to deal with its unfunded benefit obligations by sharply raising tax rates on individuals and businesses over the past few years, but the higher tax rates have backfired, according to Brookings, driving local residents and firms to other states. In 2015, for example, Illinois lost $4.75 billion in adjusted gross income to other states, according to 1RS data.
"The new federal restrictions on SALT deductions ring the death knell for this strategy of raising state taxes to meet unfunded benefit obligations," Brookings suggests. "For instance, middle-class residents of these four states are already paying effective tax rates of 9 to 12 percent--from local income, property and sales taxes. Since Congress has now limited SALT deductions to $10,000, residents of high-tax states are likely to push hard on their elected officials to lower local income and property taxes."
States could also deal with unfunded benefit obligations by making substantial cuts in...