Washington’s Quiet Tax Hike on Main Street

As Congress deliberates the future of the state and local tax (SALT) deduction cap, it's imperative to recognize the critical role that SALT deductions play for pass-through entities—businesses that form the backbone of the American economy.

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced a $10,000 cap on SALT deductions for individuals, impacting many small business owners who report business income on their personal tax returns. In response, over 30 states implemented pass-through entity tax (PTET) workarounds, allowing these businesses to pay state taxes at the entity level, thus preserving the deductibility of these taxes at the federal level.

However, recent legislative proposals threaten to dismantle these workarounds, particularly targeting specified service trades or businesses (SSTBs) such as law firms, medical practices, and consultancies. The House-passed bill includes provisions that would prevent SSTBs from deducting state and local taxes, effectively imposing an $80 billion tax hike on these businesses.

This move not only undermines tax parity between pass-through entities and C corporations—which continue to deduct all SALT payments—but also jeopardizes the financial stability of small businesses in high-tax states. Eliminating PTET mechanisms could reduce GDP by 0.2% and the capital stock by 0.3%, indicating broader economic repercussions.

Moreover, the proposed changes diverge from the principle of tax neutrality by creating differential treatment among business types, potentially leading to inefficiencies and distortions in business decision-making. In high-tax states like New York, the removal of PTETs could result in businesses paying an additional $5 to $6 billion in federal taxes, with some firms facing a 50% tax hike due to the loss of deductions.

As the SALT deduction cap is set to expire at the end of 2025, Congress faces a pivotal decision. Maintaining or enhancing SALT deductions for pass-through entities is not merely a matter of tax policy; it's about safeguarding the vitality of Main Street businesses that are integral to the nation's economic fabric.

Lawmakers must ensure that tax reforms do not disproportionately burden small businesses, especially those already navigating the complexities of high state and local taxes. Protecting SALT deductions for pass-through entities is essential for promoting economic growth, preserving jobs, and upholding the principles of tax fairness and neutrality.