Get Rid of the State-Tax Deduction Altogether

(Bloomberg Opinion) -- The 2017 tax law capped at $10,000 the amount of state and local tax payments a household can deduct from its federal income taxes. Previously, people could deduct the entire amount they paid in state and local property taxes, and either the state individual income tax or state sales tax.

According to a Treasury Department estimate released Tuesday, this cap will stop 10.9 million tax filers from writing off these payments from their federal income taxes, with the largest bite felt in high-tax states like New York, New Jersey and California. Though politicians from these states are howling — New York Governor Andrew Cuomo recently met with President Donald Trump to discuss his concerns — limiting this deduction was the right thing to do. Congress should go all the way and repeal what remains of it.

Importantly, just because 11 million people may lose this popular tax break — which has been in the federal code since the income tax was created a century ago — does not mean that all of them will be paying a larger share of their income in federal taxes. An analysis by the Tax Policy Center in December 2017 found that 80 percent of households would receive a tax cut in 2018, while only 5 percent will face a tax increase. (As temporary provisions of the 2017 law expire, more households will face a tax increase in future years.)

An initially appealing argument in favor of this deduction is that it reduces an individual’s marginal income tax. Imagine you are in the 35 percent income tax bracket and you earn an additional $100. Say you owe $10 in state taxes on that extra income. If you can deduct the $10 state tax payment, you now pay 35 percent on the remaining $90. Overall, you get to keep $58.50 after taxes. If you can’t deduct the $10, you can only keep $55 after taxes.

So far, it seems that the deduction lowers marginal tax rates, improving incentives to work, save and invest.  That’s only part of the story. By shrinking the federal income tax base relative to what it would be without the deduction, raising any given amount of revenue requires higher tax rates. This likely offsets the deduction’s marginal rate reduction.

The state and local deduction also encourages taxpayers to itemize their deductions rather than take the standard deduction. This leads people to use other deductions more as well, amplifying the harm done from much less defensible tax breaks, like the one for mortgage interest payments. For the reasons I mentioned above, we should want a broader base and lower rates, not a smaller base and higher rates.

In addition, the state and local deduction is a subsidy to states with large numbers of high-income individuals. Because they face higher marginal income tax rates, deductions are relatively more valuable to this group of taxpayers. (If you are in the 12 percent bracket, a deduction saves you 12 cents on your next dollar of income, compared with 35 cents if you are in the 35 percent bracket.)

Also, rich states are often high-tax states. And because states with high-income residents also have larger populations (New York, New Jersey, California, Illinois), the state and local deduction benefits places that are doing much better than many others, and distorts the tax-and-spending decisions made by these states’ governments.

Supporters of this write-off argue that it prevents double taxation — to stop the same dollar of income from being taxed by both the federal and state government, taxes paid to the state should be excluded from income subject to federal tax.

But that argument doesn’t really hold. State and local taxes are essential payments for goods and services, like schools, roads, police and fire departments, and public parks. Higher-tax states choose to provide more, or a better quality, of these services. Lower-tax states make a different choice.

Properly understood, state and local taxes don’t reduce your ability to pay federal income tax, and don’t tax the same dollar of income twice. Instead, they reflect a choice you made to live in a place in which the government provides a certain set of goods and services to taxpayers.

Residents of lower-tax states should not be on the hook for spending decisions of governments in higher-tax states.

Of course, higher-income households (many of which are located in higher-income states) do pay relatively more income tax, which is used to finance federal spending programs and transfer payments, some of which benefit citizens in other, lower-income states. Federal programs (like those that make up the social safety net) are supposed to operate this way, and the nation as a whole needs to decide how much to spend on them.

This is a separate issue from the state and local deduction, which distorts the decisions of state governments and finds citizens in one state financing the decisions of different states’ governments.

State and local spending finances some public goods, like education. And there is a role for government to subsidize education, because the benefits of an educated citizenry extend beyond the individuals enrolled in school. It would be better to directly subsidize education than to use a roundabout state and local deduction to achieve that goal.

Importantly, the $10,000 cap mitigates some of these concerns. For example, the cap and the larger standard deduction — another feature of the 2017 tax law — will lead many fewer households to itemize.

It doesn’t eliminate them, however. And the remaining deduction is significant. According to the Joint Committee on Taxation, 16.6 million tax filers will still claim the state and local tax deduction in 2018. Because of this subsidy, the federal government is estimated to have lost $20 billion in revenue last year.

Congress should get rid of the deduction entirely. To minimize disruption, the deduction should be set on a gradual glide path toward zero over a number of years.

Doing so might mean that high-income people leave high-tax states, although the benefits to them of living in major urban centers makes me suspect that relatively few will do so. Even if this does happen to a significant degree, it would not be something to bemoan. Households should decide where to live based on their preferences, not on tax policy.

The real change would be in the behavior of states. Some would still choose to provide more services than others — this key feature of the U.S.’s federalist system would remain. But they won’t be relying on a subsidy from the federal government — from taxpayers in other states — to pick up part of the tab.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Michael R. Strain is a Bloomberg Opinion columnist. He is director of economic policy studies and resident scholar at the American Enterprise Institute. He is the editor of “The U.S. Labor Market: Questions and Challenges for Public Policy.”

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