About That State and Local Tax Deduction

A couple of days ago I criticized Mitt Romney for thinking that eliminating the deductions for mortgages on second homes and for state and local taxes would pay for his 20 percent rate cuts. But there’s a more important general point to be made.

The deduction for state and local taxes is a subsidy from the federal government to state and local governments. This is how it works: If you’re in the 35 percent tax bracket, for every $100 of taxes you pay to state and local governments, the federal government gives you $35. In other words, for every $100 of taxes levied, you pay $65 and Barack Obama pays $35. That’s called a subsidy. Without it, the state and local governments would only get $65—or they would have to raise taxes by over 50 percent, which would make you mad.

So eliminating this deduction basically transfers money back from states and municipalities to the federal government. The federal budget deficit goes down, but state and local budget gaps go up—meaning either higher taxes or lower services. (And these are the levels of government that pay for teachers, police, firefighters, etc.) So this is one of those solutions that helps the federal budget balance by hurting ordinary people.

That said, I still think we should get rid of the deduction because it’s a highly inefficient subsidy. It mainly benefits rich people because poor people tend not to itemize their deductions. (Their deductions aren’t big enough to be worth itemizing.) Since state taxes are not very progressive to begin with, this makes them even less progressive, or even regressive. Massachusetts, for example, basically has one tax rate—5.3 percent—so people who take the deduction are paying a lower effective rate than people who don’t take the deduction.

In addition, rich towns get bigger subsidies than poor towns, simply because they have higher property values and hence people pay higher property taxes. If Greenwich needs more money for its schools, it can increase property taxes. Residents might grumble, but they know that for every $2 they pay, the federal government is kicking in $1. In Hartford, not so much.

For these reasons, in White House Burning we recommend phasing out the state and local tax deduction entirely (p. 212). In order to reduce the damage to state and local finances, however, we recommend using half of the proceeds to fund direct grants to states and municipalities. If this were done using a population-based formula, the effect would be to reduce subsidies to Greenwich much more than to Hartford; it might even increase the amount of federal aid to poor cities, where relatively few people take the deduction today.

If, by contrast, you simply axe the deduction, you’re just transferring money from one level of government to another. At the least, that’s a problem you need to acknowledge—unless it’s a feature, not a bug.

This post originally appeared at The Baseline Scenario and is posted with permission.

One Response to "About That State and Local Tax Deduction"

  1. DMK   May 2, 2012 at 8:43 pm

    Sorry James, I am not understanding the end of the second paragraph. How do state and local governments wind up with only $65 dollars if the deduction is eliminated? Clearly, individuals will have less after tax income when the deduction is eliminated, but I am missing how local governments are short changed.