The deduction of state and local income taxes or general sales taxes on federal returns is one of many “tax expenditures” being considered for elimination as part of a major tax reform effort in Congress. According to a new study by the nonpartisan Tax Foundation, simply eliminating the deduction could harm the economy, but pairing such a policy with an across-the-board cut to income tax rates would produce strong employment growth, along with boosts to GDP and federal revenues.
According to a conventional static revenue estimate, eliminating this deduction would raise federal revenue by $68 billion in 2012 dollars. The Tax Foundation’s dynamic model, however, predicts eliminating the deduction for state and local income taxes or general sales taxes would cause economic harm. Once the economy has fully adjusted, GDP would be $74 billion lower than otherwise, and because of the negative economic feedback, the revenue gain would be smaller than the static estimate, at $50 billion.
Expanded GDP, More Jobs
“Although simply eliminating the deduction could damage the economy, if we paired the deduction with an across-the-board individual rate cut of 5.8 percent, we see a rather different outcome,” said Tax Foundation Fellow Michael Schuyler, Ph.D. “GDP would expand by a net $24 billion, and federal tax collections would increase by a net $6 billion. From a growth perspective, this is an attractive trade.”
Although simply eliminating the deduction would reduce employment by about 251,000 jobs, using the revenue gain from eliminating the deduction to pay for a rate cut would increase employment by the equivalent of approximately 300,000 full-time jobs, the study found. After-tax wages would also receive a boost.
“When considering a path for comprehensive tax reform, it is critical to not lose sight of what is most important,” said Tax Foundation President Scott Hodge. “In addition to policies that simplify the tax code, we need policies that effectively foster economic growth. Pairing the state and local income tax or general sales tax deduction with an individual rate cut is one such policy.”
Source: Tax Foundation
Michael Schuyler, Ph.D. and Stephen Entin, Tax Foundation Fiscal Fact No. 382, “The Deduction of State and Local Income Taxes or General Sales Taxes”: http://heartland.org/policy-documents/case-study-4-deduction-state-and-local-income-taxes-or-general-sales-taxes