Scrapping State, Local Tax Deduction May Not Aid States

By Che Odom

Cash-strapped states and local governments likely won’t benefit from the most significant proposal by Republicans and the White House for broadening the federal income tax, according to state tax practitioners.

The single biggest base broadener for income taxes under consideration appears to be a proposal to eliminate the federal deduction for taxes paid to state and local governments. The state and local tax deduction has been part of the federal code in some form since 1913.

“That base-broadener is not going to help states as much, so this is not going to be the same story as 1986,” Karl Frieden, vice president and general counsel of the Council On State Taxation, said July 28 during the Advanced State and Local Tax Institute at Georgetown University Law Center. “The state and local tax deduction has a huge negative feedback to the state, increases the real cost of state income tax.”

Many have said that broadening the federal taxable base would give states more revenue, because most states piggyback off the federal code when it comes to taxable items. In 1986, the last time the federal government made sweeping changes to the tax code, states saw more revenue without altering their rates because the scope of items subject to tax widened.

Ending the state and local tax deduction would subject an additional $1.3 trillion to $1.7 trillion to tax over 10 years, according to the Tax Policy Center and the Tax Foundation, respectively. But that won’t help states—33 of which expect budget gaps this year or next, according to the Center on Budget and Policy Priorities.

Important to Fund Reform

Elimination of the deduction becomes important to GOP tax reform plans, given the failure to replace and repeal the Affordable Care Act and its related taxes, according to some observers.

A group of GOP lawmakers, along with Treasury Secretary Steven Mnuchin and White House economic adviser Gary Cohn, haven’t released a tax reform plan. However, in a July 27 joint statement, officials said that a proposal involving tax changes to business income on imports and exports was no longer on the table.

The House blueprint drafted by House Speaker Paul D. Ryan (R-Wis.) and outline released by the White House earlier this year called for an end to the state and local deduction, Kyle Pomerleau, director of the Tax Foundation’s federal projects, said at the Georgetown conference.

“If it is eliminated, it would be a tax increase on individuals in states that have higher rates,” he said.

Such states include California, New York, New Jersey, Massachusetts, and Illinois.

Blue States Push Back

Most congressional Republicans are committed to ending the deduction, arguing that many taxpayers who take the deduction will still benefit from overall tax rate reductions. Taxpayers with incomes exceeding $100,000 would have the largest tax increases both in dollars and as a percentage of income if the deduction is nixed, the Tax Policy Center said.

Bruce Fort, counsel with the Multistate Tax Commission, said he isn’t sure just how much controversy the deduction will create. “It is yet to be seen how much of a push back we’ll see from the states,” Fort said at the conference.

Several blue-state Republican members of Congress, including Reps. Tom MacArthur and Rodney Frelinghuysen of New Jersey, and Reps. Peter King and Claudia Tenney of New York, have said they support the deduction.

Generally, the GOP sees it as a subsidy to those blue states, allowing them to have higher tax rates without paying as much of a political price, Gary Gasper, co-leader of the Washington Council Ernst & Young practice of Ernst & Young LLP, said.

People shouldn’t assume that ending the deduction will only affect individual taxpayers, Gasper added. Businesses, including partnerships and possibly C corporations, which encompass publicly traded companies, could be impacted, he said.

“Probably they would draw the line on C corps,” Gasper said.

To contact the reporter on this story: Che Odom at COdom@bna.com

To contact the editor responsible for this story: Jennifer McLoughlin at jmcloughlin@bna.com

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