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Annette Nellen

Goodbye State Tax Deduction

How the itemized deduction for state and local taxes could survive upcoming efforts to reform AMT and our tax system. Are you up to speed?

May 8, 2008
by Annette Nellen, CPA/Esq.

The 1984 Treasury Department report (PDF) that laid the foundation for the base broadening and rate reductions of the Tax Reform Act of 1986, called for complete repeal of the itemized deduction for state and local taxes. Citing similar reasons, the 2005 final report of the President’s Advisory Panel on Federal Tax Reform also called for repeal. Yet, there are also proposals to make permanent the ability to deduct either state income or sales tax (for example, HR 3592, 110th Congress).

Below we’ll get some background on the state and local tax deduction and then look closer at arguments both for and against the deduction to understand why it will be part of broader tax reform discussions in years to come.

Brief History

The deduction for state and local taxes dates back to 1913 when the federal income tax was introduced. The Tax Reform Act of 1986 repealed the deduction for sales tax. The American Jobs Creation Act of 2004 allowed individuals to deduct either state income tax or sales tax starting in 2004; this provision expired after 2007 (Congressional Research Service, Federal Deductibility of State and Local Taxes (PDF), November 2007).

Data

The following data are from a 2008 Congressional Budget Office (CBO) report on the deduction.

  • About 35 percent of individuals itemize deductions.
  • For 2004, the average tax deduction per return that claimed the deduction was $6,767. The range was a high of $13,109 in New York to a low of $3,508 in Alaska.
  • For 2007, the deduction reduced federal tax collections by about $50 billion.
  • Distribution of the benefit of the tax deduction for 2004:

Adjusted Gross
Income (AGI) Range ($)

Percentage of tax benefits

0 – 40,000 3.7
40,000 – 75,000 15.7
75,000 – 100,000 14.2
100,000 – 200,000 29.5
200,000 – 500,000 13.6
500,000+ 23.3

The Arguments

Strong arguments can be made to repeal, retain or expand the tax deduction. A summary of key arguments follows:

Ability to pay: Under an ability to pay perspective, mandatory tax payments represent funds not available for paying other taxes. Thus, a tax deduction is justified in order to measure ability to pay.

The counter-argument is that taxpayers derive both direct and indirect benefits from sub-national taxes. Direct benefits might include tree trimming while indirect benefits include a safer community due to police protection. These benefits are not included in income and thus, expenditures to produce the benefits should not be deductible.

Tax on a tax: When a portion of one’s income is used to pay taxes, inclusion of that income in the tax base results in a tax paid on a tax. Yet this concern appears to be somewhat unimportant because most states do not allow a deduction for federal taxes paid and the federal government does not allow a deduction for all taxes paid.

Spillover: While taxpayers benefit from taxes paid, others benefit as well, including sometimes, taxpayers in other jurisdictions. To the extent there are spillover benefits, a federal deduction is warranted.

The counter-argument is that taxpayers have control over their sub-national taxes through voting and decisions on where to live. Thus, if the taxes yield spillover benefits, the taxpayers should not be compensated by higher taxes on others.

President Bush’s Advisory Panel noted that the tax deduction provides a subsidy for public services that should be “treated like any other nondeductible personal expense, such as food or clothing” with the cost “borne by those who want them — not by every taxpayer in the country.”

Lack of control/inefficient subsidy: Since the federal government does not control state and local tax systems, the tax deduction reduces the federal government’s control over its own revenues and what it chooses to subsidize.

The deduction can affect state and local tax system design. For example, criteria suggested by the California Legislative Analyst’s Office to evaluate tax proposals includes whether any new taxes are deductible for federal income tax purposes so that the state can “shift” tax burden to the federal government.

The burden is really shifted to other taxpayers. Also, the tax deduction yields greater benefits to itemizers in high tax states. The federal government is unable to shield taxpayers in low tax states from subsidizing taxpayers in high tax states. Some might argue that direct federal subsidies would be preferable over the indirect subsidies that result from the tax deduction.

Cost: The tax deduction is one of the largest federal “tax expenditures” in terms of revenues not collected due to the deduction. The 1984 Treasury report justified repeal by describing the deduction as “one of the most serious omissions from the Federal income tax base (PDF).” A counterargument ties back to ability to pay and the proper measure of the income tax base. Some would argue that a focus on “tax expenditures” leads to the view that all income belongs to the government (for example, see Joint Economic Committee, Tax Expenditures (PDF), 1999).

Fairness: Deductions provide a greater benefit to individuals in higher tax brackets relative to those in lower brackets. Also, the benefit of the tax deduction is greater for itemizers in high tax states (although reduced by the AMT). Some individuals pay higher federal taxes to offset the reduced revenues from the deduction.

Considering that taxpayers do get benefits from sub-national taxes, the 1984 Treasury report noted the following fairness concern (PDF): “Allowing a deduction for State and local taxes simply permits taxpayers to finance consumption expenditures with pre-tax dollars.”

On the other hand, fairness was the argument used to support the return of the sales tax deduction in 2004. Some would argue that the fairness of the deduction would be improved by broadening it to cover more types of taxes, rather than curtailing it. This approach might also lessen the importance of federal tax rules on decisions of sub-national governments over the types of taxes they impose (although taxes would still be favored over user fees).

Relevance in tax system reform: Due to the size of the tax deduction in terms of reduced federal revenues, repeal is often suggested in order to allow broadening of the income tax base and lowering of rates. Repeal would also reduce the number of itemizers, providing additional simplification. Federal reform proposals also include replacing the income tax with a consumption tax, which has no deduction for sub-national taxes.

Proposals

In addition to the proposals noted earlier, the 2008 CBO report on the deduction, prepared at the request of the Senate Budget Committee, analyzed five proposals for the tax deduction:

  1. repeal
  2. a two percent of AGI limit
  3. a $5,000 cap, adjusted annually for inflation
  4. replacement with a 15 percent non-refundable credit
  5. repeal except for real estate taxes

Looking Forward

Itemizing and AMT have already eliminated the state and local tax deduction for many individuals. Will policymakers continue to chip away at it further?

The state and local tax deduction mostly survived the 1984 call for its repeal, yet its imperfections have once again been noted and it will be on the table in upcoming tax reform discussions. These discussions have begun as evidenced by Congressman Rangel’s reform proposal (H.R. 3970, 110th Congress) and a Senate Finance Committee hearing on April 15, 2008. Proposals will include base broadening with rate reductions, as well as a consumption tax to replace the income tax. These discussions, along with AMT reform considerations, will involve examination of the state and local tax deduction, as well as other tax preferences.

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Annette Nellen, CPA/Esq., is a tax professor and Director of the MST Program at San José State University. She is also a fellow with the New America Foundation. Nellen is an active member of the tax sections of the AICPA and ABA. She has several reports on federal and state tax reform and a blog.