NCPA - National Center for Policy Analysis

THE FIGHT OVER STATE AND LOCAL TAX DEDUCTIONS

November 24, 2004

President Bush is considering elimination of the deduction for state and local taxes as part of tax reform. While this is defensible tax policy, it will be extraordinarily difficult to pull off unless it is combined with something incredibly popular that Congress is forced to accept as a package deal, says Bruce Bartlett.

For example, when Ronald 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, says Bartlett:

  • 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 to 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, says Bartlett.

Source: Bruce Bartlett, "The Fight Over State and Local Tax Deductions," National Center for Policy Analysis, November 24, 2004.

 

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