The relationship between federal and state governments – the division of power between the two levels being known as federalism – is an integral part of the American constitutional system. Federalism uses separate and competing spheres of sovereignty to check the growth and power of government as a whole.
Unfortunately, that system has been steadily eroded by a series of policies that have empowered the federal government, weakened states, made states dependent upon the largess of Washington, or encouraged excessive growth of state governments. As Curtis Dubay of the Heritage Foundation writes in a recent Issue Brief, the latter is accomplished in part through a federal deduction for state and local taxes that shields residents in high tax states from feeling the full cost of their bloated local governments.
Dubay writes:
The tax code allows taxpayers to deduct certain state and local taxes, including income taxes, sales taxes for residents of states that (wisely) go without an income tax, real estate taxes, and personal property taxes. State and local income taxes makes up about 95 percent of all state and local tax deductions.
…The harmful unintended consequence of the deduction is that it encourages state and local governments to raise their taxes. Higher taxes allow state and local governments to grow larger because they spend up to the maximum amount of revenue they can collect.
The deduction encourages state and local governments to raise their taxes because it transfers a portion of their tax burdens from their residents to the federal government. For instance, for every dollar a state taxes a family paying the 33 percent federal marginal tax rate, the family effectively pays only $0.67 of the state tax, because the deduction on the family’s federal taxes reduces their federal tax bill by $0.33.
This reduction in the “price” of the state’s taxes encourages states to raise their taxes higher than they otherwise would, because taxpayers offer less resistance since they do not pay the full cost of the higher taxes. Taxpayers are more willing to accept higher taxes because of the deduction in the same way consumers are more willing to buy a product or service when prices fall.
Dan Mitchell has similarly pointed to the faults in the state and local tax income tax dedication, as well as potential wrong headed solutions to its distortions:
Under current law, state and local income taxes are fully deductible, but state and local sales taxes are only temporarily deductible. The right policy is to get rid of any deductibility for any state and local tax…
Not surprisingly, the crowd in Washington doesn’t take this approach. Instead, they want to extend deductibility for the sales tax. And they may even be amenable to raising other taxes to impose that policy.
…This is a very misguided policy. It means that greedy politicians such as Governor Brown of California or Governor Cuomo of New York can raise tax rates and tell voters not to get too upset because they can deduct that additional burden. This means that a $1 tax hike results in a loss of take-home pay of as little as 65 cents.
But you don’t cure one bad policy with another bad policy. A deduction for state and local sales taxes just augments the IRS-enforced preference for bigger government at the state and local level.
Dubay further explains how eliminating the deduction would benefit tax competition and limited government:
These data show that while taxpayers in high-tax states pay a hefty amount of state and local taxes, they also see that burden reduced the most because of the deduction. If tax reform eliminated the deduction, these taxpayers would see the biggest increase in their effective state and local taxes. They would likely put the most pressure on their state and local governments to stop tax increases and apply the most pressure on those governments to reduce their high taxes.
Like Mitchell, he also notes that offsetting elimination of the deduction is essential to reform:
Eliminating the state and local tax deduction should be done only within the context of overall tax reform. Congress should not eliminate it (for instance, through “loophole closing”) without other offsetting tax changes. To do so would be an unnecessary tax increase.
The state and local tax deduction is just one of many policies distorting the federalist system and encouraging excessive government growth. Federal mandates, grants, handouts and other tax preferences also undermine tax competition and need reform.
