As members of Congress and the Obama administration creep ever closer to a deal to raise the debt ceiling, it becomes increasingly clear any plan that emerges will rewrite the nation’s tax code.
And when it comes to taxes, leaders in both parties have agreed it makes sense to trade many current targeted deductions–“loopholes” to those who disdain them–for lower marginal tax rates. Some deductions for people who drive certain types of cars or buy new air conditioners are self-evidently silly, but getting rid of them in isolation won’t make much difference even if every dollar in revenue that flows in is passed along to the public in the form of lower rates.
Congress needs bigger targets if it hopes to lower rates. And one of the biggest targets of all–the $70 billion-plus per-year deduction for state and local taxes–deserves scorn from both sides of the aisle. Conservatives have every reason to dislike the enormous implicit subsidy it provides to areas with big, high-tax governments. Liberals should disdain its regressive nature.
Since the dawn of the modern income tax, some sorts of local levees have always been deductible from federal tax bills. Right now, most property taxes, almost all state income taxes, and a few sales taxes get written off on the form 1040s that individuals file each April.
This encourages tax hikes. Allowing the deductibility of state and local taxes provides a nearly limitless federal subsidy to state and local governments that raise taxes. Every time a state or local legislature votes to take more of its citizens’ income, the deduction ensures the federal government’s revenues will decline by a certain percentage. The higher the states raise their taxes, the greater the federal tax benefits that accrue to their citizens and the larger the implicit subsidy the state government receives from the feds.
Thus states and localities that keep taxes modest are at a disadvantage. In addition, although people are certainly sensitive to tax rates, the fact that they can deduct state tax increases from their federal returns lessens the sting and makes raising state taxes, on balance, an easier political task than boosting federal levees. The state and local tax deduction is thus a subsidy for big government.
It is also a tax loophole that benefits the well-off more than anyone else. Truly poor people generally don’t own homes that would require them to pay property taxes, and most state income taxes place little or no obligation on those of modest means. Wealthy people pay the lion’s share of local taxes–a point the liberal Center for American Progress loves to make–and therefore get a much bigger benefit from the federal deduction than do the poor.
Almost everyone who files a tax return has the potential of getting something out of the state and local tax deduction. Thus, eliminating it without cutting effective rates elsewhere would almost certainly represent the sort of broad-based tax increase everyone says they want to avoid, rather than a simple “loophole closing.” Thus those who favor lower taxes have every right to insist that any elimination of the deduction be matched, dollar-for-dollar, with a tax cut elsewhere.
In any case, in the final analysis the state and local tax deduction is a bad public policy that warrants widespread opposition.