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Economic Analysis: Repeal of SALT Deduction More About Politics Than Policy

POSTED ON Jul. 11, 2017
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In the scavenger hunt for revenue raisers, the low-hanging fruit is the deduction for state and local taxes. The other two big individual itemized deductions, mortgage interest and charitable contributions, are protected by an impenetrable brick wall of raw political power shrouded in a mist of moral rectitude.

It has become commonplace for tax reform plans to include total repeal of the state and local tax deduction while only trimming or leaving entirely untouched the mortgage interest and charitable deductions. Examples of this approach include various modified versions of the original flat tax; both of the plans suggested by President George W. Bush’s tax reform panel in 2005the tax reform proposal included in the Rivlin-Domenici commission’s deficit reduction plan in 2010; the comprehensive tax reform plan proposed by former House Ways and Means Committee Chair Dave Camp in 2014; many Republican candidates’ tax reform proposals in the 2016 campaign; the blueprint for tax reform championed by House Speaker Paul D. Ryan, R-Wis., and Ways and Means Committee Chair Kevin Brady, R-Texas; and the one-page statement of tax reform principles released by the Trump administration on April 26.

Although Republicans usually recoil at any type of tax increase, cutting this tax break would almost be fun for them. As shown in Table 1, it provides massively disproportionate deductions to high-tax states controlled by Democrats.

Table 1. State and Local Tax Deduction by State, 2014

 

Deduction for State and Local Taxes

Type of Tax Deducted

Percentage
Of Taxpayers Paying AMT

 

Jurisdiction

Billions

As Percentage 
Of AGI

As Percentage
Of Itemized Deductions

Income Taxes

Sales Taxes

Property Taxes

New York

$68.4

9.1%

58.3%

69%

1%

29%

5.1%

New Jersey

$30.6

8.7%

56.4%

51%

1%

47%

6.2%

Connecticut

$13.6

8.3%

57.2%

61%

0%

36%

5.7%

California

$101.1

7.9%

48.3%

70%

1%

26%

4.7%

Maryland

$16.5

7.7%

44.5%

71%

0%

28%

4.6%

Oregon

$7.7

7%

45.8%

69%

0%

30%

2.9%

District of Columbia

$2

6.8%

46.4%

81%

0%

18%

6%

Rhode Island

$2.1

6.4%

50.1%

54%

0%

40%

2.8%

Massachusetts

$18.1

6.3%

50.5%

61%

0%

36%

4.9%

Minnesota

$11.5

6.2%

47.9%

71%

1%

26%

3.3%

Illinois

$25.5

6%

48.9%

52%

1%

45%

3.4%

Wisconsin

$10

6%

49.6%

59%

1%

38%

2.2%

Vermont

$1

5.6%

49.6%

53%

0%

46%

2.4%

Maine

$1.9

5.6%

48.5%

59%

0%

36%

2.1%

Virginia

$15.5

5.5%

40.5%

63%

0%

32%

3.7%

Pennsylvania

$19

4.9%

45.3%

56%

1%

42%

2.6%

Georgia

$ 12.4

4.9%

35.1%

66%

1%

28%

2.3%

Nebraska

$2.7

4.8%

45%

61%

1%

33%

2.2%

Iowa

$4.1

4.7%

44.1%

62%

1%

32%

2%

Ohio

$14.7

4.7%

46.3%

62%

1%

36%

2.1%

Kentucky

$4.6

4.7%

43.3%

73%

1%

22%

1.7%

North Carolina

$11.5

4.7%

37.9%

67%

1%

28%

2.1%

Utah

$3.4

4.5%

30.6%

70%

1%

27%

1.9%

Hawaii

$1.8

4.5%

35%

79%

1%

18%

2%

Delaware

$1.2

4.5%

37.4%

72%

0%

26%

2.3%

Montana

$1.2

4.5%

38.7%

69%

0%

28%

2%

Idaho

$1.6

4.4%

35.5%

70%

2%

27%

1.7%

New Hampshire

$2.1

4.3%

41.5%

24%

0%

71%

2.3%

Missouri

$6.7

4.3%

39.7%

65%

1%

28%

1.8%

Michigan

$11.4

4.3%

41.8%

56%

1%

39%

1.9%

South Carolina

$4.7

4.2%

35.6%

70%

1%

22%

1.7%

Colorado

$7.1

4%

34.8%

68%

1%

27%

2.6%

Kansas

$3.1

3.8%

37.8%

56%

4%

34%

1.8%

Arkansas

$2.4

3.7%

36.5%

76%

3%

18%

1.6%

Indiana

$5.9

3.5%

38.5%

71%

1%

24%

1.5%

Arizona

$5.6

3.5%

29.3%

55%

6%

32%

1.6%

Oklahoma

$3.1

3.2%

29.3%

69%

3%

27%

1.7%

New Mexico

$1.4

3.1%

30.6%

63%

3%

32%

1.4%

West Virginia

$1.2

3%

41.1%

79%

1%

16%

1.3%

Mississippi

$1.8

3%

27.6%

62%

6%

25%

1.1%

Washington

$7.1

2.9%

27.6%

10%

29%

58%

1.9%

Alabama

$3

2.8%

25.7%

70%

4%

20%

1.1%

Louisiana

$3.1

2.6%

28.1%

68%

5%

23%

1.7%

Florida

$14.6

2.6%

26%

20%

19%

58%

1.6%

Texas

$20.3

2.5%

28.9%

7%

23%

67%

1.9%

Nevada

$1.9

2.4%

21.4%

27%

24%

40%

1.1%

Tennessee

$3.1

1.9%

22.8%

16%

37%

45%

0.9%

North Dakota

$0.4

1.6%

28.8%

57%

4%

37%

1.5%

South Dakota

$0.4

1.6%

23.4%

16%

23%

57%

1.2%

Wyoming

$0.3

1.6%

18.5%

29%

19%

40%

1.4%

Alaska

$0.4

1.5%

22.6%

7%

7%

82%

1.1%

Other areas

$1

1.7%

38.5%

62%

2%

24%

2.5%

U.S. total

$515.9

5.3%

43%

60%

3%

35%

2.9%

Source: Author’s calculations using IRS Statistics of Income data by geographic areas, available online at http://www.irs.gov/uac/soi-tax-stats-individual-income-tax-return-form-1040-statistics.

A Closer Look

The more than 100 million taxpayers who don’t itemize may not deduct state and local taxes. The Tax Reform Act of 1986 repealed the deduction for state and local sales taxes, but in 2004 Congress temporarily allowed taxpayers the choice of deducting sales or income taxes, and at the end of 2015 it made that option permanent.

The significant geographic disparity of deductions shown in Table 1 does not take into account other aspects of the tax system that can significantly affect the deduction, such as differences in average state tax rates, limitations on deductions, and the alternative minimum tax. Average federal tax rates are undoubtedly higher in high-income states. Higher rates make deductions more valuable, so if differences in tax rates are taken into account, the disparity in benefits is greater than the disparity in deductions shown in Table 1.

On the other hand, the benefits of the deduction for state and local taxes face two significant obstacles that reduce the observed geographic disparity. First, there is the Pease limitation, which reduces itemized deductions by up to 20 percent for high-income taxpayers (specifically, in 2016 for single individuals with $259,400 of adjusted gross income and married couples with $311,300 of AGI).

Contrary to popular belief, because of the particular way the Pease limitation works (as a backdoor marginal rate increase on high-income taxpayers), it does not decrease the marginal incentive to increase these deductions (Joseph Rosenberg, C. Eugene Steuerle, and Katherine Toran, “What Does the Fiscal Cliff Deal Mean for Nonprofits?” Urban-Brookings Tax Policy Center (Jan. 2013)). Nevertheless, the limitation still reduces taxes for itemizers who pay state and local taxes. Accordingly, it reduces the benefit of state and local taxes proportionately more in high-income states than low-income states. Using aggregate data for 2014, this author’s calculations indicate that the limitation reduced itemized deductions by $44.8 billion in 2014. This average reduction of itemized deductions of 3.6 percent of AGI is larger in high-income states than low-income states.

Second, and more importantly, because state and local tax payments aren’t deductible against the individual AMT, the deduction has limited benefits for taxpayers on the AMT. The lack of deductibility of state and local taxes is by far the major reason that there were 4.2 million AMT taxpayers in 2014. Leonard Burman, Eric Toder, and Christopher Geissler estimated that without the AMT, the aggregate tax benefits of the state and local income tax would double (“How Big Are Total Individual Income Tax Expenditures and Who Benefits From Them?” Urban-Brookings Tax Policy Center Discussion Paper No. 31 (Dec. 2008)).

The last column in Table 1 shows, as one should expect, that the AMT is far more prevalent in high-tax, high-income states than elsewhere. For example, in New York 5.1 percent of individuals pay AMT, while in Mississippi the figure is only 1.1 percent. Therefore, the AMT reduces the benefits of the state and local tax deduction more in high-tax states than low-tax states (Congressional Budget Office, “The Deductibility of State and Local Taxes” (Feb. 2008)).

Table 2. Estimated Tax Increase From Repeal of Deduction For State and Local Taxes in 2016

Jurisdiction

Reduction in After
Tax Income

Taxpayers With Tax Increases

Average Tax Increase

Connecticut

1.5%

34.9%

$1,495

New Jersey

1.4%

32.9%

$1,157

New York

1.4%

26.9%

$1,142

District of Columbia

1.3%

31.6%

$1,122

Maryland

1.2%

39%

$1,001

Massachusetts

1.2%

32.1%

$1,018

California

1.1%

26.2%

$842

Rhode Island

1%

28%

$654

Illinois

0.9%

26.6%

$678

Minnesota

0.9%

31.6%

$714

Oregon

0.9%

29%

$573

Virginia

0.9%

32.5%

$757

Wisconsin

0.9%

27.8%

$585

North Carolina

0.8%

25.2%

$478

Pennsylvania

0.8%

23.5%

$512

Colorado

0.7%

29%

$532

Delaware

0.7%

28%

$517

Georgia

0.7%

24.2%

$436

Kansas

0.7%

22.5%

$459

Maine

0.7%

24.9%

$457

Nebraska

0.7%

24.4%

$465

Ohio

0.7%

24%

$468

Utah

0.7%

29.6%

$440

Vermont

0.7%

23.6%

$468

Arizona

0.6%

22.9%

$348

Hawaii

0.6%

23%

$389

Idaho

0.6%

23.4%

$358

Iowa

0.6%

25.4%

$429

Kentucky

0.6%

21.4%

$357

Michigan

0.6%

21.7%

$393

Missouri

0.6%

22.4%

$413

Montana

0.6%

23%

$359

New Hampshire

0.6%

28%

$485

South Carolina

0.6%

22.2%

$358

Arkansas

0.5%

18.1%

$291

Indiana

0.5%

19%

$301

New Mexico

0.5%

17.8%

$250

Oklahoma

0.5%

19.3%

$324

Alabama

0.4%

20.6%

$250

Florida

0.4%

14.9%

$216

Louisiana

0.4%

17.2%

$238

Mississippi

0.4%

17.1%

$209

North Dakota

0.4%

16.5%

$268

Washington

0.4%

24.1%

$299

West Virginia

0.4%

13.6%

$230

Alaska

0.3%

18.4%

$182

Nevada

0.3%

17.1%

$186

Texas

0.3%

16.2%

$235

South Dakota

0.2%

12.8%

$130

Tennessee

0.2%

14.8%

$138

Wyoming

0.2%

15%

$141

United States

0.8%

23.6%

$ 555

Source: Frank Sammartino and Kim Rueben, “Revisiting the State and Local Tax Deduction,” Urban-Brookings Tax Policy Center (Mar. 31, 2016).

It seems plausible that as tax reform evolves, options under consideration could include plans that repeal the individual AMT and omit repeal of the deduction for state and local taxes. In this case, the benefit of the deduction of state and local taxes would be greatly expanded — contrary to the wishes of most Republicans. Alternatively and less likely, if the reverse were to come about — that is, if tax reform were to repeal the deduction for state and local taxes and not repeal the AMT — it would greatly reduce the scope of the AMT. In high-tax states, the AMT and the deduction for state and local taxes are highly interrelated.

Fortunately, state-by-state calculations are available from the Tax Policy Center using its simulation model that takes into account all the complex interactions of the deduction with rates, the Pease limitation, and the AMT, and calculates the net tax effect of the deduction on taxpayers by state. These estimates are shown in Table 3. Although there are some important differences in the ranking of individual states, the net effect doesn’t change the general picture presented in Table 1. The deduction strongly favors Democratic-leaning states (Frank Sammartino and Kim Rueben, “Revisiting the State and Local Tax Deduction,” Urban-Brookings Tax Policy Center (Mar. 31, 2016)).

The Politics

It won’t be a cakewalk to dislodge a deduction as old as the code itself. If we ever get down to brass tacks on tax reform, it is likely that the saga of the deduction for state and local taxes will proceed in two parts. Part 1: To pay for lower rates, Republican leaders with the support of the majority of their rank and file will propose eliminating or severely limiting the deduction for state and local taxes. That’s potentially a $1.3 trillion tax hike over 10 years, according to the Tax Policy Center.

Part 2: A small but pivotal cadre of House Republicans from affluent districts in high-tax states will likely deny Republicans the 213 votes they need for passage of tax reform if it includes repeal of the deduction. Table 3 shows that if the 38 House Republicans from five high-tax states — New York, New Jersey, California, Illinois, and Minnesota — don’t vote for tax reform, Republicans would fall 10 votes short. Already, according to the June 23 New York Post, 7 out of 9 New York Republicans, as well as several other Republicans from high-tax states, have voiced their opposition to cutting the deduction.

Table 3. Party Affiliation of Congressional Delegations From States With Above-Average Benefits From Deduction for State and Local Taxes

Jurisdiction

Tax Benefit as Percentage of ATI (2016)

Deduction as Percentage of
AGI (2014)

U.S. House of Representatives

U.S. Senate

Republican

Democrat

Republican

Democrat

Connecticut

1.5%

8.3%

0

5

0

2

New Jersey

1.4%

8.7%

5

7

0

2

New York

1.4%

9.1%

9

18

0

2

District of Columbia

1.3%

6.8%

0

0

0

0

Maryland

1.2%

7.7%

1

7

0

2

Massachusetts

1.2%

6.3%

0

9

0

2

California

1.1%

7.9%

14

39

0

2

Rhode Island

1%

6.4%

0

2

0

2

Illinois

0.9%

6%

7

11

0

2

Minnesota

0.9%

6.2%

3

5

0

2

Oregon

0.9%

7%

1

4

0

2

Virginia

0.9%

5.5%

7

4

0

2

Wisconsin

0.9%

6%

5

3

1

1

Total U.S.

0.8%

5.1%

241

194

52

48

Total above average

n.a.

7.5%

52

114

1

23

Total below average

n.a.

3.6%

189

80

51

25

Sources: Tables 1 and 2 and https://pressgallery.house.gov/member-data/party-breakdown. “ATI” is after-tax income.

Some high-tax-state Republicans will argue that other cuts in tax reform will offset the loss of the deduction. For example, Ways and Means Committee member Devin Nunes, R-Calif., “supports getting rid of the deduction for state and local taxes, and pairing it with doubling of the standard deduction and additional child-focused tax relief.” (See “GOP Plan to Ax State-Tax Deduction Would Hit California Hardest,” San Francisco Chronicle, May 6, 2017.)

Without at least some big chunk of that $1.3 trillion available to taxwriters, individual reform is pretty much dead in the water. This is undoubtedly one major reason why President Obama limited his tax reform proposals to the corporate sector.

The Policy

Given the striking redistribution of the federal tax burden from blue to red states caused by the deduction, its proposed elimination is as appealing as any tax increase can be for Republicans. But repeal of the deduction for state and local taxes is more than just red meat for red-state Republicans. There is some solid policy justification for repeal. The reasoning is straightforward. If expenditures by state and local governments are like spending on private goods (or, if you want to be fancy, quasi-private goods consumed on a collective basis), they aren’t expenses that reduce the ability to pay federal taxes but just plain old consumption. According to this view, state and local governments are just intermediaries providing services that directly benefit taxpayers. In this case, more economically efficient outcomes would be achieved if local governments imposed nondeductible fees and user charges for their services.

“Expenditures by State and local governments provide benefits primarily for residents of the taxing jurisdiction,” stated Treasury in its 1984 landmark report on tax reform. “To the extent that State and local taxes merely reflect the benefits of services provided to taxpayers, there is no more reason for a Federal subsidy for spending by State and local governments than for private spending.” Treasury acknowledged that benefits from local spending might spill over to other jurisdictions and justify some federal support, but it didn’t consider these effects significant. In 2005 the President’s Advisory Panel on Federal Tax Reform concluded that “these expenditures should be treated like any other nondeductible personal expense, such as food or clothing.”

To this one may ask: What if a taxpayer (presumably in the minority) dislikes the bundle of services provided by state and local governments? For example, if the local majority has decided to spend disproportionate sums on schools and swimming pools, and you’re a childless aquaphobic, how are your mandated payments to the local government like purchases at Walmart? In response to this, clever economists routinely cite the seminal economic work of Charles M. Tiebout that suggests that optimal provision of public services will be restored because taxpayers will move to jurisdictions where local governments provide the level and composition of services that best match taxpayers’ preferences for government spending (“A Pure Theory of Local Expenditures,” J. of Pol. Econ. 416 (1956)).

It’s true that many locally provided services are similar or even identical to what individuals would otherwise purchase on their own. Trash collection and access to a municipal swimming pool are good examples. Also, higher taxes may pay for a better quality of life in the form of cleaner streets, better police protection, and bigger parks that primarily benefit local residents. In these circumstances, services funded with state and local taxes are clearly similar to private consumption and deserve no deduction.

Comparison to Charitable Deduction

But the supposition that state and local expenditures are analogous to private spending only goes so far. It is a fact that a large proportion of state and local spending is dedicated to purposes and institutions whose funding would be eligible for a charitable contribution deduction if that funding were provided directly by a taxpayer. Table 4 shows that in 2014, more than 60 percent of the $2.7 trillion in state and local expenditures was devoted to education, public welfare, and public health. Why should a taxpayer get a deduction for charitable deductions to schools, social welfare organizations, and the arts, but be denied a deduction for state and local taxes that promote the same causes?

Table 4. State and Local Government Spending, Fiscal 2014

Expenditure by Function

Billions

Percent of Total

Higher education

$269

9.9%

Other education

$646

23.9%

Public welfare

$543

20%

Hospitals and health

$261

9.6%

Transportation

$192

7.1%

Public safety

$235

8.8%

Environment and housing

$190

7%

Administration

$129

4.8%

Interest

$107

4%

Other

$136

5%

Total

$2,707

100%

Source: U.S. Census Bureau, State and Local Government Finance, available at http://www.census.gov/govs/local. Total does not include expenditures by public utilities, liquor stores, and insurance trusts.

The argument is sometimes made that an individual acting on his own can deliver support more efficiently to charitable causes than local governments can. That may or may not be true. But it seems plausible that support for a charitable cause resulting from local collective decision-making is at least as worthy of federal support as a cause reflecting an individual’s private tastes. In a 2015 paper, Rachel Greszler and Kevin Dayaratna argue that the “deduction subjects federal tax revenues to the whim of state governments” (“Time to End the Federal Subsidy for High-Tax States,” Heritage Foundation Backgrounder No. 2999 (Mar. 25, 2015)). Are the whims of governments subsidized by the deduction for state and local taxes less deserving than the whims of private donors subsidized by the deduction for contributions?

“Thrifty Wyomians are helping to pay for the extravagance of New York,” observed Thomas R. Dye in support of the effort of tax reformers to repeal the deduction for state and local taxes during the Reagan administration (Cato Journal 59 (Fall 1985)). That effort failed, as vividly described by Jeffrey H. Birnbaum and Alan S. Murray in their account of the passage of the Tax Reform Act of 1986 (Showdown at Gucci Gulch 124-128 (Vintage 1987)). More recently, Jeremy Horpedahl and Harrison Searles echoed the same point still routinely made in conservative circles: “Removing the federal tax deduction for state and local taxes would make taxes more equitable throughout the nation, as both high-tax and low-tax states [would be] treated equally by the federal government” (“The Deduction of State and Local Taxes From Federal Income Taxes,” Mercatus Center (Mar. 6, 2014).

It is without question that this redistribution across states exists, and that the net losers naturally will be less favorably inclined — if not outright hostile — to a tax subsidy for the winners. It is not at all clear, however, that geographic neutrality should be a guiding principle for tax policy. If a deduction is considered valid, either as an adjustment to help measure a taxpayer’s ability to pay or as a delivery mechanism to subsidize a worthy cause, it should be allowed irrespective of the fact that some jurisdictions benefit more than others. For example, residents of Utah in 2014 deducted charitable contributions (equal to 4.7 percent of AGI) at more than twice the U.S. average rate (2.2 percent of AGI). Does this type of disparity mean we should repeal the charitable deduction?

Numerous other examples of differences across states abound in the code. Solar energy credits do little for the overcast Pacific Northwest, and wind energy credits do little for the Southeast, where average wind speeds are nothing like they are in Iowa. Is the uneven distribution across regions a policy justification on its own for cutting these subsidies?

Other Questions

The argument is often made that the federal government should not be subsidizing state and local government spending that is assumed to be wasteful. Jason Pye writes that if the deduction were eliminated, “the perverse incentive state legislatures have to increase taxes to finance a big government policy agenda through a subsidy in the federal tax code will be diminished” (“Tax Reform Should End the Deduction for State and Local Taxes to Finance Lower Tax Rates,” FreedomWorks, May 9, 2017). In a blog post, Daniel J. Mitchell of the Cato Institute calls New York and California lawmakers “greedy politicians” and argues that “the federal tax system rewards profligate high-tax states such as New York and California with a permanent deduction for state and local income taxes” (“It’s Wrong for Federal Tax Deductions to Encourage Bad Fiscal Policy by State and Local Governments,” Sept. 30, 2012). This common complaint about the inefficacy of state and local governments by conservative commentators is somewhat puzzling given their penchant in other contexts to laud state and local governments, especially compared with the federal government.

Nevertheless, if downsizing federal support for state and local deductions is the objective, why focus only on the subsidy provided by the deduction for state and local taxes? In 2014 the federal government routed more than $600 billion in funds to state and local governments. These funds routinely require conformity — at high administrative cost to the states — with all sorts of rules and mandates from lawmakers and regulators in Washington. They are federal meddling in local affairs on a massive scale. In contrast, the federal subsidy provided to state and local governments through a deduction for their taxes comes with no strings attached.

In the tax code, we could also encourage reduced state and local government spending by limiting tax subsidies for the issuance of public purpose municipal bonds. Along with most Republicans, the Trump administration strongly favors eliminating the deduction for state and local taxes. But rarely do we hear parallel arguments about limiting the exclusion for interest received from state and local bonds. Treasury Secretary Steven Mnuchin told the Senate Finance Committee on May 25: “Our preference is strongly to keep the interest deductibility of state and local bonds.” Yet on April 25, as he defended the administration’s proposed repeal of the state and local tax deduction, Mnuchin incongruously stated: “We don’t think it’s the federal government’s job to be subsidizing states.”

Economic Growth?

Contrary to the stated primary purpose of tax reform, the elimination of the deduction for state and local income taxes does not provide an incentive for economic growth. Table 1 shows that nationwide, 60 percent of the deduction for state and local taxes is for income taxes. Dollar-for-dollar, a reduction in federal tax rates paid for by a reduction in the deduction for federal taxes leaves the total combined state and federal marginal tax rate unchanged.

For example, under current law $100 of income subject to a 30 percent federal rate and a 10 percent state rate has a marginal tax of 37 percent. The federal government receives $27, and the state government receives $10. If the deduction is repealed, the federal government on a revenue-neutral basis can reduce its rate to 27 percent. It will still receive $27, the state government will still receive $10, and the overall marginal rate will still be 37 percent. In this case, with marginal rates unchanged, there is no incentive for expansion of labor supply or capital spending that is central in most models that predict growth from tax reform.

This puts elimination of the deduction for state and local income taxes in a different category than elimination of most other tax expenditures. Repeal of most tax expenditures does not result in an increase in marginal tax rates. For example, if the federal government cuts a tax credit by $3, it can reduce the federal rate to 27 percent and the combined state-federal rate will be reduced to 34.3 percent (= 27 percent + (1 - 0.27) * 10 percent) for those taxpayers who itemize. Most base broadening in a classic revenue-neutral tax reform lowers marginal rates. Eliminating the deduction for state and local income taxes does not. (Another example of a major proposed base-broadening provision that doesn’t lower marginal rates is elimination of the section 199 deduction for income from domestic manufacturing and production.)

Less Government?

The above calculation that indicated no change in the combined state-federal effective tax rate as a result of the repeal of the state and local tax deduction assumes that state and local governments don’t cut taxes in response to the loss of deductions. Opponents of the deduction certainly hope that its elimination will make taxpayers more cost-conscious and put downward pressure on state and local taxes. But is there evidence that limiting the deductibility of taxes will in fact reduce taxes and the size of state and local governments?

As usual, it’s difficult to get a definitive answer from economists. In its 2008 report (cited above), the CBO concluded that there was relatively little evidence to suggest that the deduction increased spending on services. In contrast, a 2011 paper by Gilbert E. Metcalf cites four studies that suggest that deductibility enlarges state and local government spending (“Assessing the Federal Deductions for State and Local Tax Payments,” Nat’l Tax J. 565 (June 2011)). A separate question is what effect the deduction has on the composition of state and local funding sources. On this economists do agree: The deduction will cause governments to shift their sources of revenue to deductible taxes and away from nondeductible taxes and fees.

Progressivity

One of the more prominent criticisms by opponents of the state and local tax deduction is that it disproportionately favors high-income households. Mitchell has argued that it should be repealed “because the federal tax system has ‘progressive’ tax rates that discriminate against those with higher incomes, [and] the deduction is more valuable to a rich taxpayer than it is to a poor taxpayer” (“The Deduction for State and Local Taxes Undermines Tax Reform and Subsidizes High-Tax States,” Heritage Foundation (July 25, 2005)). Table 4 shows CBO estimates of the percentage of tax benefits for major tax expenditures that accrue to the top 5 percent of taxpayers across income classes of major tax expenditures. Taxpayers in the top 5 percent get 49 percent of the benefit of the deduction for state and local taxes — more than the deduction for mortgage interest (38 percent), but less than the deduction for charitable contributions (59 percent).

Table 5. Percentage of Individual Tax Expenditure Benefits Accruing to Taxpayers With Highest 5 Percent of Income

Tax Expenditure

 Percentage of Benefit to All Taxpayers

Exclusion for employer-sponsored health insurance

10%

Tax benefits for pension contributions and earnings

36%

Capital gains on assets transferred at death

49%

Deduction for state and local taxes

49%

Deduction for mortgage interest

38%

Deduction for charitable contributions

59%

Capital gains and dividend preference

82%

Earned income tax credit

0%

Child tax credit

0%

Source: Congressional Budget Office, “The Distribution of Major Tax Expenditures in the Individual Income Tax System” (May 29, 2013).

Another interesting possibility is that if repeal of the deduction causes a reduction in state income taxes (which seems most likely because higher-income-state taxpayers benefit most from the deduction), there could be a reduction in the progressivity of state taxes because income taxes are states’ most progressive taxes. This would partially offset the increase in progressivity of federal taxes (Kirk J. Stark, “Fiscal Federalism and Tax Progressivity: Should the Federal Income Tax Encourage State and Local Redistribution?” UCLA L. Rev. 1389 (2004)). This potential shift in the incidence of the benefit of the state and local deduction from statutory taxpayers is not captured in tables that mechanically distribute federal return data across income categories.

Whatever the incidence of the deduction for state and local taxes may be, it is important to remember, as in any evaluation of a particular tax expenditure, that progressivity is a standard that really only makes sense when applied to the tax system as a whole. Phasing out tax benefits for separate tax expenditures (which was especially prominent in Clinton administration proposals) adds complexity and clandestinely raises marginal tax rates. What matters is the progressivity of the overall system, not of individual provisions. It is of course entirely possible (and desirable) to have many provisions in the tax code that individually are regressive and still have a system that is progressive overall. If in their next tax reform, Republicans retain the goal set forth by Camp in 2014 — that tax reform should be distributionally neutral — the distributional effects of retaining the deduction for state and local taxes can be easily offset by an adjustment to the progressive rate structure or by the retention or expansion of tax expenditures that favor low- and middle-income taxpayers.

Pivot Point

The fate of the deduction for state and local taxes is a bellwether for the future of tax reform. The critical question is how many blue-state Republicans will object to cutting the deduction for state and local taxes. If Republican leaders can’t bring enough of them into the fold, there will be insufficient revenue available to significantly reduce individual tax rates. Once this sinks into the congressional consciousness, there will be even more talk of business-only tax reform, as Obama proposed. But voters won’t tolerate being excluded, no matter how economically sensible it may be to prioritize a corporate rate reduction.

Without cutting the deduction for state and local taxes, Congress is left with no other options but to massage tax reform into a major tax cut or enact no major tax legislation at all. Because the latter would be political suicide for Republicans, expect a tax cut.