Getting Rid of State and Local Tax Deductions

March 19, 2014

Allowing deductions for state and local taxes only keeps federal tax rates higher, say Jeremy Horpedahl, assistant professor of economics at Buena Vista University, and Harrison Searles, a Mercatus Center MA Fellow.

Taxpayers are allowed to deduct the taxes that they pay to their state and local governments from their federal taxable income. The idea is to provide tax relief to those in high tax states. However, the deduction simply serves to subsidize high taxes and spending because taxpayers in high-tax states do not feel the full burden of those taxes. Instead, it is taxpayers in low-tax states that bear the burden of the taxes because federal tax rates must be raised in order to accommodate those state and local deductions and fund federal spending.

  • In 2012, the ability for individuals to deduct their individual income taxes reduced federal tax revenue by $45 billion, according to Office of Management and Budget estimates.
  • State and local deductions also incentivize governments to choose deductible taxes rather than more efficient taxes.
  • And these deductions do increase state and local spending, as recent estimates show that such spending would drop without deductibility.

Eliminating the deduction would lead to increased macroeconomic activity and potentially more federal tax revenue (depending on how individuals react to what would serve as a tax increase). Were tax rates decreased along with the elimination of the deduction, federal revenue would remain the same and economic activity would be generated. A study by the Tax Foundation found that getting rid of the state and local income and sales tax deduction, while simultaneously cutting income tax rates by 5.8 percent, would lead to a 300,000 job increase.

Removing the deduction for state and local taxes would make the tax code fairer, as high and low tax states would receive equal treatment by the government. Moreover, states and localities would become more efficient as they turned certain services over to private hands.

Source: Jeremy Horpedahl and Harrison Searles, "The Deduction of State and Local Taxes from Federal Income Taxes," Mercatus Center, March 6, 2014.

 

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