The new federal cap on income tax deductions could translate into higher interest costs for Connecticut and other wealthy states when they borrow for school construction and other capital projects, a Wall Street credit rating agency warned Tuesday.
Moody’s Investors Service said the new U.S. Treasury Department rules aimed at preventing high-income taxpayers from working around new limits on the deductibility of state and local taxes constitutes a “credit negative” for states like Connecticut, California, New Jersey and New York.
A negative is not a formal downgrade of the state’s bond rating. Rather it is a warning about a specific development that could — often in concert with other negatives — lead to a rating reduction, and potentially higher borrowing costs.
Connecticut issued more than $2.5 billion bonds on Wall Street last fiscal year to finance a wide array of initiatives including: municipal school construction; highway, bridge and rail upgrades; capital projects at public colleges and universities; renovations to state buildings; improvements to wastewater treatment systems and other clean water programs; farmland and open space preservation; and various, community-level projects.
The cap “will likely dampen housing price growth in high-tax states and states with a high percentage of SALT filers by removing an incentive for homeownership,” Moody’s analysts wrote. SALT is the acronym used to describe the deduction for state and local taxes.
As housing values fall, so will assessments and, ultimately, local property tax receipts — unless cities and towns in states like Connecticut respond by increasing property tax rates, or state government spends more on aid to municipalities.
“With a cap on SALT deductions, voters in some municipalities will be more likely to reject tax increases because they will not be partially offset by a federal tax benefit,” analysts added.
These negative economic factors, coupled with the potential budget problems it poses for state and local governments here, led Moody’s to issue the credit negative.
The deduction federal income tax filers can take for paying state and local taxes was capped by the Republican-controlled Congress last winter at $10,000, effective in the 2018 tax year — which impacts returns households will file next spring.
The cap is seen as a punitive measure against Connecticut and other Blue States, where taxes are often higher than those in Republican-dominated states.
According to the nonpartisan Urban-Brooks Tax Policy Center, the average SALT deduction in Connecticut was roughly $19,000 per filer in 2014.
Connecticut, New York, New Jersey and Maryland filed a lawsuit in federal court in July challenging the constitutionality of the new limit on the grounds that it interferes with state’s taxing authority. Restricting deductions for state and local taxes — which pay for core services such as education and public safety — is akin to the federal government dictating how states should spend in these key areas, they argued.
Connecticut and other states also tried to work around the federal changes by altering state laws.
For example, Connecticut enacted a law that allows municipalities to create “community supporting organizations” classified as charitable organizations. Taxpayers would make “contributions” to these organizations and most — but not all – of those donations would be credited against their local tax liability, thereby lowering it.
Since there is no cap on charitable donations in the new federal tax system this would have allowed Connecticut taxpayers to work around the $10,000 cap on SALT deductibility.
But the new IRS rules say taxpayers can receive a federal tax write-off equal only to the difference between the state or local tax credits they get and their charitable donations.
That means a Connecticut taxpayer who makes a $25,000 charitable donation to pay property taxes and receives a $23,000 state tax credit would only be able to write off $2,000 on a federal tax bill.
Gov. Dannel P. Malloy called the Republican tax changes “an affront to middle class Connecticut families and a massive giveaway to the wealthiest individuals and largest corporations, and the guidance issued by the Trump administration today only makes it worse.”
Responding last week to the new IRS rules, Malloy added that “we already know that 83 percent of the benefits from this law go to the top one percent, while taxes actually increase for many middle class Connecticut families – at the same time it causes our federal deficit to explode by $1.5 trillion.”
Democratic gubernatorial nominee Ned Lamont also issued statement last week, saying, “This ruling only hurts working families. … Eighty-three percent of those who will benefit from Trump’s tax reform bill are the wealthiest top 1 percent.”