The state and local deduction

Bruce Bartlett
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Posted: Nov 23, 2004 12:00 AM

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.

 The main argument against eliminating the deduction is that it would constitute a massive tax increase on some states that would decimate their finances. Back in 1986, every political leader in the state of New York -- then, as now, a very high-tax state -- made this argument ad nauseam. New York Gov. Mario Cuomo was the No. 1 advocate of retaining the deduction.

 Although the argument was usually overwrought, people like Cuomo had a point. If the state and local deduction constitutes a subsidy, then its withdrawal will penalize those who make the most use of it. The whole point is to change governmental behavior by encouraging state tax cuts, contracting out and privatization of state services, and shrinkage of the public sector.

 The most principled argument in favor of the state and local tax deduction is federalism -- the federal government should not be imposing itself onto state and local tax decisions. That is why the state and local tax deduction was made part of the income tax when it first came into existence in 1913 and has remained part of the tax code ever since.
 
Conservative arguments against eliminating the state and local tax deduction include concerns that states will switch from personal income taxes to businesses taxes, which would remain deductible as a business expense in any case. This could diminish economic growth. Also, it is said that it is fundamentally unfair not to allow a deduction for taxes because they reduce taxpayers' income and are something over which they have no control.

 Ultimately, the case for retaining the state and local tax deduction -- or at least the combined lobbying pressure of the states and their Washington representatives -- proved compelling, and the deduction was retained in the Tax Reform Act of 1986. That same pressure will have to be overcome again if Bush plans to take another run at it.

 One thing that may tilt the playing field a little more against the deduction this time is that the Alternative Minimum Tax has already heavily eroded it. For those who must pay the AMT, no deduction for state and local taxes is presently allowed. This is a key reason why those in high tax states tend to pay more in federal taxes than they get back in federal spending.

 Still, the political fight will be furious. It cannot hope to succeed unless the payoff is big enough to create a countervailing political force. I think only a low flat-rate tax with no deductions for anything has that potential.