According to press reports, President Bush is considering elimination of the deduction for state and local taxes as part of tax reform. While defensible tax policy, I don't think he realizes just how extraordinarily difficult such an action will be. Unless it is combined with something incredibly popular that Congress is forced to accept as a package deal, I see little likelihood of this measure being enacted.
In 1984, President Reagan asked the Treasury Department to study tax reform. It recommended elimination of the deduction for state and local taxes mainly on the grounds that it subsidized consumption through government. As Treasury's report explained:
The current deduction for state and local taxes in effect provides a federal subsidy for the public services provided by state and local governments, such as public education, road construction and repair, and sanitary services. When taxpayers acquire similar services by private purchase (for example, when taxpayers pay for water or sewer services), no deduction is allowed for the expenditure. Allowing a deduction for state and local taxes simply permits taxpayers to finance personal consumption expenditures with pre-tax dollars.
When Reagan sent his tax reform proposal to Congress in May 1985, it emphasized fairness, saying the state and local taxes deduction mainly benefited those with high incomes and those in high-income states. Because the loss of revenue is large, requiring higher federal tax rates, the result is that low-income taxpayers and those in low-income states in effect subsidize the rich.
These are still valid arguments. The states that benefit most from the state and local deduction are those with the highest taxes, which generally are those with the highest per capita incomes. Because the top federal income tax rate is 35 percent, in effect the top state and local income tax rate is reduced by 35 percent. A state rate of 10 percent is really only 6.5 percent when federal deductibility is taken into account.
This encourages states to impose higher tax rates than they might otherwise adopt, have governments provide services that the private sector might better be able to deliver and finance such services with deductible taxes rather than nondeductible fees that might be more efficient. Low-tax states and those without income taxes in effect underwrite these larger governments and higher taxes.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
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