Magazine | May 29, 2017, Issue

Tax Federalism

Ending the state-and-local deduction would help make blue states pay their way

At this early stage in the debate over President Trump’s tax plan, much of the discussion has centered on his proposal to eliminate the state-and-local-tax deduction. Conservatives have long viewed closing this loophole as the great lost cause of President Reagan’s 1986 tax reform, though it has sometimes been criticized by Democrats as well. Everyone agrees that repealing the state-and-local-tax deduction would disproportionately affect blue states, where taxes are high and rising due to ongoing fiscal strain. It might be possible to make good on the Trump administration’s pledge of one of the biggest tax cuts in American history without targeting this particular deduction. But it probably won’t be possible to do so in a fiscally responsible way.

When a filer tallies up how much he owes the IRS in a given year, a deduction shrinks his “adjusted gross income,” creating a smaller base to which the federal income-tax structure is applied. The theory is that you shouldn’t have to pay full income taxes on earnings that you used to cover certain unavoidable or justifiable expenses. Seventy percent of households claim the standard deduction, currently $12,600 for a married couple filing jointly. The remaining 30 percent “itemize” deductions, and more or less all of them claim state and local taxes paid. They take how much they paid in property and income or, in rarer instances, sales taxes and multiply that sum by their top marginal federal income-tax rate (the highest is now 39.6 percent). This figure may then be subtracted from their taxable earnings.

By granting filers the right to claim as a deduction the taxes they have paid to other governments, federal law essentially gives states and cities first dibs on taxable income. For this reason, the state-and-local-tax deduction has always held an appeal for many federalists. It holds an even stronger appeal for filers in the upper income-tax brackets and for blue-state politicians. According to the most recent data from the IRS, only 4 percent of all filers had an adjusted gross income of $200,000 or more, but this cohort represented 13 percent of all those who itemized taxes paid and accounted for 47 percent of the total amount claimed. The more income you earn, the more likely you are to itemize deductions, the more property taxes and state and local income taxes you are likely to owe each year, and the higher your top marginal federal income-tax rate is likely to be.

As for blue-state officials, they appreciate how the deduction exports a portion of the high taxes they impose on households to federal taxpayers. The larger a jurisdiction’s tax burden, the larger the subsidy it receives via the federal tax code. The ten states that Hillary Clinton won most decisively, which are home to 31 percent of the total population, enjoyed 54 percent of the value of the state-and-local-tax deduction.

But the deduction has long had many detractors as well. It is rare to come across a policy proposal pitched as “tax reform” that does not somehow target it. If you want to cut tax rates or free up revenues for some other purpose without exploding the deficit, then you need to go where the money is. Among tax expenditures for individuals, only those related to health and retirement benefits ($235 billion and $140 billion, respectively, in the 2018 fiscal year) and capital gains ($108 billion) cost more than the state-and-local-tax deduction ($103 billion). The deduction is inefficient with respect to the tax code (because lost revenue must be recaptured via higher rates) and from a fiscal-policy standpoint.

Taxpayers should be brought as close as possible to the cost of government. Not only does the deduction reduce the “tax price” of public services by subsidizing them; it also creates — because only general forms of taxation are deductible — an incentive to rely more on income and property taxes than on user fees. As the Tax Policy Center has noted, unlike most forms of aid to states and cities tracked by the federal Office of Management and Budget, the state-and-local-tax deduction is subject to practically no oversight. The Hillary Clinton and Bernie Sanders campaigns both called for limiting the state-and-local-tax deduction because of how much it benefits high earners.

But however broad the support for repealing or reducing this deduction may sometimes seem, we won’t know how deep it runs until the tax-reform battle is truly joined. Much would hinge on whether those freed-up revenues were repurposed toward new tax breaks or programs or toward cutting rates, and on who would benefit. New York, New Jersey, Illinois, and California are home to 35 House Republicans, or roughly the same number as the Freedom Caucus’s membership. Given how much revenue is at stake with this particular deduction, blue-state Republicans in Congress could thwart or water down tax reform in a manner similar to the way in which the Freedom Caucus brought down the first iteration of the American Health Care Act in March.

In trying to game out the implications of eliminating the deduction, it is important to appreciate the strain under which the blue-state fiscal model now labors. This model is characterized by high taxes made necessary by robust public services and commitments to generous pay and benefit packages for unionized work forces. State and city Democrats stubbornly refuse to acknowledge any tension between those two priorities, but it is very real. Many progressives would like to significantly expand services, but their ability to do so is now highly constrained by retirement-benefit costs.

According to the most recent data from the Census Bureau, state and local general revenues increased 36 percent over the previous decade, whereas public-pension costs doubled. Since state and local governments are nearly always subject to balanced-budget requirements, increased spending on pensions leaves that much less for education, infrastructure, safety-net programs, and so on. New York City politicians are at present up in arms over potential federal cuts to public housing. But city government would be much better positioned to address the New York City Housing Authority’s $17 billion maintenance backlog had it not also run up $150 billion in unfunded retirement-benefit liabilities. Taxes are already high in blue states (they dominate the top rankings of the Tax Foundation’s annual report “State-Local Tax Burden”), but the dreadful math on public pensions makes further income- and property-tax increases a question of when, not if. This means that, without a course correction, federal taxpayers are set to shoulder an even greater share of states’ and localities’ fiscal irresponsibility in coming years.

Many households in the middle and upper-middle class benefit from the state-and-local-tax deduction. But the GOP plan would significantly shield them from the impact of its elimination by doubling the standard deduction to around $25,000. Many households that had found it economic to itemize would instead opt for the standard deduction (the average total deduction claimed for filers making less than $500,000 is about $23,000). As for the highest earners, who on average benefit the most from the deduction and are also most capable of relocating or reorganizing their finances, they might choose to move out of blue states for more-favorable tax jurisdictions. Outmigration can be deadly for a fiscal model that’s highly reliant on income inequality. In California, Connecticut, and New York City, around half of all personal income taxes are paid by filers who report more than $500,000. Texas and Florida do not have a state income tax, and their already strong appeal would be intensified by the elimination of the state-and-local-tax deduction.

Providing no-strings-attached general Treasury support for states and cities with a long record of putting off difficult fiscal choices doesn’t strengthen federalism. It weakens it. On many social issues, state and local Democratic politicians are busy trying to develop their own brand of “progressive federalism.” That’s fair enough, but when it comes to their benefit programs and work forces, they should expect to pay their own way. Federalism is a two-way street. Eliminating the taxes-paid deduction would, fiscally speaking, be a way to test whether progressive federalists have the courage of their convictions.

– Mr. Eide is a senior fellow at the Manhattan Institute.

Stephen Eide — Stephen Eide is a senior fellow at the Manhattan Institute.

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