Thursday, May 19, 2005

Tax Reform: State Tax Deductions?

Taxes are always the product of a rate times a base. Our federal income tax is especially complicated because the rates vary, and the base is particularly complex due to varying deductions that can be taken by taxpayers.

One idea on the table for federal income tax reform involves broadening the base by eliminating the deduction for state and local taxes. This is a very controversial idea, since lots of folks pay these taxes and wish to reduce their federal taxable income by the amount they pay to the states. If there was no deduction, you would have a tax on a tax. That sounds bad, unless you consider the state and local tax burden as a form of consumption expenditure. Thus, you are paying for roads, schools, parks, and things like this that may benefit you. Of course, there are also expenditures for lots of things that don’t benefit you at all, and you may well be paying more than what seems to be your fair share. The federal government does not have a monopoly on wasteful practices.

The state and local tax deduction is an itemized deduction that is worth a lot to taxpayers. According to IRS statistics of income figures for 2002 (preliminary), taxpayers deducted a total of $289 billion in state and local taxes on their returns. This is second only to mortgage interest ($343 billion), and it is higher than the amount of charitable contributions deducted (136 billion). Some 44.7 million returns are affected, so this means a lot of voters are potentially impacted by this deduction.

Not all states are alike in their tax burdens, and citizens of high-tax states (and local jurisdictions) are especially concerned about the continuation of this deduction. I recently ran across a letter to members of the President’s Advisory Panel on Federal Tax Reform by a Congressman Charles Rangel (D, NY) on this topic, which I found interesting.

Congressman Rangel states that we should not change this deduction “so that we do not hinder the ability of State and local governments to finance their operations.” He notes that the Reagan administration had previously proposed to repeal this deduction, but “[t]hat argument was not very effective because most individuals want good roads, good schools and law enforcement, and they do not want the Federal government to take actions to increase the burden of the taxes necessary to fund those items.”

Whoa, there, Congressman. First, any Federal change here would have no impact on the authority of the states to finance their operations through taxation. They can go on taxing as they wish, subject only to the will of the people to stop them. Of course, you are on to something: taking away a federal deduction would mean that people would really have to pay the full burden of those state taxes, without getting a federal reduction that acts much like a subsidy. For example, assume a taxpayer in a 25% federal tax bracket incurs $10,000 of state and local taxes, which may otherwise be deductible. Since the $10,000 deduction reduces federal taxes by $2500, this taxpayer can effectively agree to have his legislature vote for spending, knowing that his real after-tax cost will be only 75 cents on the dollar. Some might call this a federal subsidy for the states.

Making citizens aware of the real cost of their taxes paid to whatever jurisdiction is a helpful precursor to encouraging accountability and responsibilty. It may also engender competition among states, leading to lower government costs for those who are willing to vote with their feet if they can't change the results at the ballot box. This kind of freedom is vigorous and affirming, though it vexes those who know how to spend other people's money and feel they have a right to do so.

Better accountability also addresses the second point of the good Congressman: those people who want good roads, schools and law enforcement – will have to pay the real tax burden for those improvements. And this is as it should be. We all want things, but we have to pay for them. Keeping those decisions at the level closest to the citizen is ideal.

Though broadening the tax base may seem troubling, it is an idea worth considering. Once again, it seems that the Reagan administration was on the right track.

No comments: