Misplaced Fears About the State and Local Tax Deduction Shouldn't Derail Federal Tax Reform

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Tax Policy

The state and local tax deduction may be eliminated as part of federal tax reform. In this article, the Tax Foundation's Jared Walczak discusses arguments against eliminating the deduction, and why they are misplaced fears that shouldn't stand in the way of federal tax reform.

Jared Walczak

By Jared Walczak

Jared Walczak is a senior policy analyst at the Center for State Tax Policy at the Tax Foundation.

Of late, some of the nation's highest-tax jurisdictions have evinced a touching, if convenient, concern about the prospects of double taxation. As Congress grapples with base-broadening options to help pay down the costs of pro-growth tax reform, a coalition of largely tax-happy cities and states have suddenly come to the fore as stalwart defenders, not just of the taxpayer, but of high-income taxpayers in particular.

The state and local tax (SALT) deduction allows taxpayers who itemize—only 30 percent do—to deduct taxes paid to state and local government from their federal taxable income. The deduction, one of the largest preferences in the federal income tax code, will cost an estimated $1.8 trillion over the next decade, and its primary beneficiaries are high-income earners in high-tax states. In 2014, 88 percent of its value accrued to those with incomes of $100,000 or more, and only 1 percent was claimed by taxpayers with income below $50,000.

The coexistence of federal and state income taxes absent deductibility is sometimes characterized as a tax upon a tax, as federal taxes are paid on the share of income forgone to state and local governments. The argument, of course, is not new, and at first glance it appears plausible enough to trouble those rightly concerned with an equitable tax code. Nevertheless, that the most implacable foes of eliminating a provision which ostensibly unfairly overtaxes the rich are, in many cases, also advocates for higher and more progressive taxes ought to raise eyebrows—and argues for a closer look at what is really going on.

Taxpayer's Ability to Pay

Most taxes imposed by different levels of government are susceptible to some variation of the double taxation argument, but the crux of the case for deductibility has historically been the taxpayer's ability to pay. At times when the top marginal federal individual income tax rate exceeded 90 percent, it would have been possible for some income to be taxed at combined rates in excess of 100 percent in the absence of deductibility.

It is, of course, fairly implausible to conclude that rates would have stood as high in the absence of the deduction, or that earning a marginal dollar above some threshold would actually expose the taxpayer to more than a dollar's worth of taxes. Even if such fears were warranted, however, they have little relevance under today's rate schedule, or any rates which might emerge from a tax reform package which includes the repeal of the state and local tax deduction.

But is it, nevertheless, double taxation? Hardly.

In our fiscal federalist system, each level of government (federal, state, and local) provides its own package of services, which one would expect to be “priced” separately. In many cases, they provide fundamentally different services—local utilities versus national defense. Even where multiple levels of government share responsibilities for certain varieties of expenditure (roads, for instance), each has its own discrete contribution, and taxpayers expect to contribute to each pool.

When two taxes levied by a single government or similar types of governments (for instance, multiple states) fall disproportionately upon the same income or economic activity, this represents a clear case of double taxation. The argument falls apart, however, when different levels of government levy taxes for their own sets of services. When a municipal government imposes its own local income or sales tax, no one argues that taxpayers should be able to deduct these payments from their state taxes, because they understand that, through their tax dollars, they are funding two different sets of services.

Doubtful Arguments

While some may have been convinced by doubtful arguments about double taxation, the real reason so many entrenched interests are riding to the provision's rescue is the same one that stands behind the defenses of most other tax preferences: self-interest.

The SALT deduction reduces the marginal cost of higher state and local taxes by forcing taxpayers across the country to pay for spending that mostly benefits taxpayers in a single jurisdiction. By subsidizing higher state and local spending, lower-income and lower-tax jurisdictions are forced to foot the bill for higher-income, higher-tax parts of the country. And because the cost of larger government is reduced by the subsidy, the provision encourages and rewards bigger government at the subnational level.

Taxpayers across the country take advantage of the deduction, but it represents an outflow from most states and localities into a favored few. The SALT deduction in New York and California represents 9.1 and 7.9 percent of adjusted gross income respectively, compared to a median of 4.5 percent nationally.

A regressive feature of an otherwise progressive federal income tax code, the SALT deduction depends for its survival on those who wish to use the federal tax code to subsidize larger state and local government. The Tax Foundation's Taxes and Growth Model finds, meanwhile, that the deduction's economic implications are marginal, with repeal resulting in a mere 0.4 percent reduction in GDP over a decade, which would be offset many times over if repeal were used as a pay-for in pro-growth tax reform.

The federal tax code is replete with double taxation, particularly within the corporate income tax, which reformers wish to overhaul. With tax reform a serious possibility for the first time in decades, policymakers would squander a golden opportunity if they allowed misplaced fears about the SALT deduction to stand in the way of remaking the tax code for the better.

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