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The state and local tax deduction has been described as “the most sacred of cows.” More than 95 percent of federal income tax itemizers deducted their state and local taxes in 2014. Both President Donald Trump's and the House GOP's tax plans call for eliminating the deduction. In this article, the Tax Foundation's Jared Walczak discusses the deduction's impact on state and local taxes.
By Jared Walczak
Jared Walczak is a policy analyst with the Tax Foundation.
Even in a tax code littered with supposedly sacrosanct provisions, the state and local tax deduction stands out. According to Showdown at Gucci Gulch: Lawmakers, Lobbyists, and the Unlikely Triumph of Tax Reform, Ronald Reagan lamented that it was “the most sacred of cows,” while one of his Treasury secretaries characterized it as a “dragon” to be slayed ( Birnbaum & Murray, Showdown at Gucci Gulch). The dragon prevailed.
The deduction has withstood the accusation that it is regressive, rewarding high-income taxpayers. It has persevered despite being labeled a subsidy of wealthy, high-tax states funded by the rest of the country. It has endured economists' suspicion that it distorts state and local government expenditures. In fact, our economic analysis has shown that eliminating the provision would generate substantial revenue to pay for tax rate cuts that would provide an overall net economic benefit and simplify the tax code. Thanks to the tenacious support it enjoys in some quarters, it has survived parries from the left and from the right. Now it is once again imperiled, on the chopping block in both President Donald Trump's tax outline and the House Republican tax reform plan, testing just how sacrosanct the provision really is.
Currently, taxpayers who itemize are permitted to deduct certain nonbusiness tax payments to state and local governments from their taxable income. An individual may choose to deduct either state individual income taxes or general sales taxes, but not both, and may also deduct any real or personal property taxes. Most filers elect to deduct their state and local income taxes rather than sales taxes, because income tax payments tend to be larger, but those who reside in states which forgo an income tax, or who have uncommonly high consumption expenditures, may opt to deduct sales taxes instead. The sales tax deduction may be taken either by documenting actual expenses or using optional sales tax tables based on personal income (“State and Local Tax Deductions,” Tax Notes, July 1, 2013).
In tax year 2014, more than 95 percent of all itemizers (28 percent of filers) took a deduction for state and local taxes. Roughly 21.8 percent of filers deducted income taxes, while 6.5 percent elected to deduct sales taxes instead. Most itemizers are homeowners, so 25.1 percent of filers also deducted real property taxes. Taken together, deductions for state and local taxes are estimated to be worth more than $100 billion per year by fiscal year 2018 even though most filers do not itemize.
The value of the deduction is lessened for some payers by the Pease limitation, which reduces itemized deductions by 3 percent of the amount that a taxpayer's adjusted gross income exceeds an indexed threshold, and by the alternative minimum tax (which is itself eliminated in the president's outline). President Trump would repeal the deductibility of state and local taxes outright, along with many other itemized deductions, in favor of lower rates.
Opponents of the deduction view it as a regressive provision largely claimed by wealthier taxpayers that subsidizes higher taxes and potentially wasteful spending. Proponents counter that the deduction better aligns taxable income with ability to pay and that it helps optimize local government spending. High-income, high-tax states where wealthy residents disproportionately claim the deduction have, unsurprisingly, long been the provision's most unstinting champions.
The lion's share of state and local tax deductions are claimed by upper-income earners. Only 30 percent of all federal income tax filers itemized in tax year 2014. Of these, more than three-quarters reported adjusted gross income (AGI) above $50,000, even though taxpayers with AGIs above $50,000 represent a mere 38 percent of all filers, according to IRS data. According to the Joint Committee on Taxation, more than 88 percent of the benefit of state and local tax deductions accrued to those with incomes in excess of $100,000 in 2014, while only 1 percent flowed to taxpayers with incomes below $50,000. In 1984, a Treasury report went so far as to disparage the state and local tax deduction's “distributionally perverse pattern of subsidies” (“The Deductibility of State and Local Taxes,” Publius 16, no. 3, Summer 1986, 55). The elimination of deductibility would reduce the cash income of the top decile of income earners by 1.3 percent, but the reduction would be less than 0.1 percent for each of the bottom five deciles (“Assessing the Federal Deduction for State and Local Tax Payments,” National Tax Journal 64, vol. 2, June 2011, 575).
Proponents sometimes posit that the elimination of deductibility would particularly disadvantage wealthy people who live in low-income communities, which could incentivize high-income earners to self-segregate in wealthier neighborhoods (“The Deductibility of State and Local Taxes,” National Tax Journal 38, no. 4, Dec. 1985, 448. Id., 463). Studies, however, suggest that this effect would be quite modest, if it exists at all, and that in many cases, the effect may run in the opposite direction. High-income earners who congregate in a single community, for instance, may support locally-funded amenities like golf courses and tennis courts, or more stately government buildings and costly public infrastructure, while exporting some of the resulting tax burden to others (Bruce Bartlett, “The Case for Eliminating Deductibility of State and Local Taxes,” Tax Notes, Sept. 2, 1985, 1122).
Just as the state and local tax deduction disproportionately favors wealthier taxpayers, it also benefits states which combine high incomes and high-tax environments. Reliance on the deduction varies widely. In New York, the deduction is worth 9.1 percent of AGI; the median across all states is just under 4.5 percent. More staggering, though, is the fact that just six states—California, New York, New Jersey, Illinois, Texas, and Pennsylvania—claim more than half the value of all state and local tax deductions nationwide, with California alone responsible for 19.6 percent of the national tax expenditure cost, according to IRS data.
This is not just a function of population. The state and local tax deduction expressly favors higher-income earners and state and local governments which impose above-average tax burdens. The deduction's effect is for lower- and middle-income taxpayers to subsidize more generous spending in wealthier states like California, New York, and New Jersey, reducing the felt cost of higher taxes in those states. As the Urban-Brookings Tax Policy Center has observed, state and local governments “are able to raise revenues from deductible state and local taxes that exceed the net cost to taxpayers of paying those taxes, in effect allowing those jurisdictions to export a portion of their tax burden to the rest of the nation.”
To the extent that the more generous spending is financed through progressive taxation at the state level, some of the regressive effect of the deduction at the federal level may be offset at the state level. This is, however, an inefficient and convoluted approach to promoting state tax progressivity, and whatever greater progressivity may exist in a high-income, high-tax state is countered by a federal transfer away from residents of lower-income, lower-tax states. Advocates of progressive taxation typically prefer progressivity at the federal level to progressivity at the state level, as “higher-income taxpayers can avoid progressive state and local taxes either by shifting income or physically moving to a lower-tax state.” The state and local tax deduction flips this preference on its head, sacrificing progressivity at the federal level in hopes of inducing more progressive state tax structures.
The deduction increases state and local government expenditures by reducing the cost of that spending, but estimates of the effect's magnitude differ. During the 1986 tax reform debate, the Congressional Research Service estimated that the deduction increased state and local spending by as much as 20.5 percent, while the now-defunct U.S. Advisory Commission on Intergovernmental Affairs concluded that the increase was about 7 percent and the National League of Cities arrived at an estimate of only 2 percent. Other studies have found little evidence of any significant effect on state and local government expenditure levels. Furthermore, any reductions in local expenditures “would appear to be concentrated in high income communities where most itemizers now live,” according to Edward Gramlich.
By decreasing the cost of state and local government spending, the federal government provides a subsidy for such expenditures. Because not all forms of state and local revenue are deductible, moreover, the deduction's availability can promote greater reliance on deductible income and property taxes to the disadvantage of other possible sources of revenue, including user fees, which might otherwise be favored. Using federal tax revenue to subsidize state and local governments—and particularly higher-income taxpayers—has critics on both the left and right, with the chief argument advanced in favor of the status quo predicated on the postulate that local government spending, in particular, is suboptimal.
All levels of government must strike a balance between demand for government-provided services and the desire to keep taxes and spending in check, and the democratically chosen balance will vary from place to place. Even beyond such variations, taxpayers may be more supportive of increased levels of spending if part of the cost is borne by others; conversely, they may reduce expenditures if they believe that some of the benefit of that spending will be conferred on others. Federal subsidies place a thumb on the scale, distorting local decision-making, as the Congressional Budget Office noted in a 2008 analysis of the deduction.
Some municipal services are inherently excludable; only residents, for instance, stand to benefit from municipal trash collection. Other amenities, however, like city parks, public parking, bike trails, community centers, and municipal athletic facilities, are utilized both by residents (who pay local taxes) and nonresidents (who do not). This “spillover” theoretically reduces the amount that residents are willing to pay in taxes for certain services, per Bartlett in Tax Notes. A federal subsidy, regressive though it may be, might then be rationalized as a way to restore expenditure decisions to equilibrium rather than artificially inflating demand.
Several objections to this model quickly emerge. Positive spillovers from public sector spending are more likely in low-income cities than in high-income communities,” which is one reason why, under the current systems, high-income individuals may find it even more advantageous to live together in the same communities. Moreover, the deduction is a blunt instrument, applying no matter what the possible spillover effect of an expenditure is, and without regard to the mix of services that exist in a community (Charles McLure, “Tax Competition: Is What's Good for the Private Goose Also Good for the Public Gander?” National Tax Journal 39, no. 3, Sept. 1986, 344).
Furthermore, whereas the federal government engages in a broad array of cash transfers, social insurance, and social welfare spending, such expenditures are responsible for a modest portion of state, and particularly local, budgets. Social services comprise 11.3 percent of local budgets, and general expenditures—which would include many of the amenities which might benefit nonresidents—only account for 5.6 percent of local government budgets nationwide. This suggests that, unlike federal taxes, state and especially local taxes more closely adhere to the benefit principle, and that federal subsidization of these levels of government will tend to favor taxpaying residents, not free-riding nonresidents.
A Congressional Budget Office (CBO) analysis summarized the effect of the deduction by noting that it “may spur state and local governments to provide services that are neither federal in nature nor targeted toward areas of national concern” and thus “interfere with the sorting mechanism that otherwise helps keep local public services at levels appropriate to their value to local taxpayers.” One of the virtues of federalism is the ability for state and local governments to experiment with different models of taxation and service provisions, with the recognition that what is appropriate or desirable for one population may be disfavored by another. Whatever balance communities might otherwise adopt, however, may be skewed by deductibility. As the CBO notes, “Because of the subsidy, too many of those services may be supplied, and state and local governments may be bigger as a result.”
Additionally, the existence of the deduction can incentivize government provision of municipal services that might be provided more efficiently by the private sector, because the cost, for instance, of municipal trash collection receives the benefit of the deduction, whereas private provision of waste management services would receive no such tax advantage (Jeremy Horpedahl and Harrison Searles, “The Deduction of State and Local Taxes from Federal Income Taxes,” Mercatus Center at George Mason University, March 6, 2014, 3).
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 foregone to state (and potentially local) governments. Most taxes imposed by different levels of government are susceptible to some variation of this argument, but the crux of the case for deductibility is 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.
This argument for the deduction also depends on the extent that higher levels of state and local taxation represent a choice about the consumption of government services. If state and local tax rates are largely invariant to service provision or fund services not utilized by many taxpayers, then these state and local taxes may be seen as reducing capacity to pay federal taxes. If, however, these taxes correlate strongly with services provided—and such a correlation is far stronger at the state and local level than it is at the federal level— then arguments about double taxation are less salient, particularly when variations in local government taxation can be explained in part by consumption that might otherwise have been supplied by the private sector.
In a federal system, individuals receive services from federal, state, and municipal governments. Each layer of government provides its own package of services, which one would expect to be “priced” separately. 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. When different levels of governments levy taxes for discrete sets of services, the rationale for a deduction for taxes paid is far weaker.
According to the Tax Foundation's Taxes and Growth Model, eliminating the state and local tax deduction would raise an additional $1.8 trillion in federal revenues over a ten-year window on a static basis, and $1.7 trillion on a dynamic basis, which takes changes in economic activity into account. The adverse economic impact is estimated at a modest 0.4 percent reduction in gross domestic product (GDP), which would be more than counterbalanced by any offsetting rate reductions. The small impact on economic growth makes it an enticing offset for more growth-oriented, revenue-reducing reforms elsewhere in the system.
Distributionally, the lower four quintiles of households would see their after-tax income decrease by 0 to 0.7 percent on a static basis under the deduction's repeal. Households in the highest quintile would experience a tax increase of 2.2 percent on their income. Dynamic effects, which take into account changes in behavior associated with taxes, are slightly larger.
Increasingly a costly anachronism which favors high-income earners in wealthy states, the state and local tax deduction has long outlived its usefulness. As such, it is an attractive “pay-for” to provide a revenue offset to rate reductions or other reforms. Political opposition may be stiff, but if overcome, repealing the state and local tax deduction would make for a better, more neutral tax code.
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