As the debate over the “fiscal cliff” continues between the White House and House Republicans, some constituencies have begun the usual “don’t tax me, tax the guy behind the tree” defense of their favorite tax preferences.
The angst is higher than usual because Republicans have sought to hold the line on tax rates and are pushing for revenue to be raised by scaling back deductions for high-income taxpayers. One such deduction that has survived previous tax reforms although it has always been on the chopping block is the deduction for state and local taxes. That deduction appears to be on the table this time around.
The state and local deduction allows an itemizing taxpayer to deduct for federal tax purposes the amount paid to state and local governments in property and income (or sales) taxes. Obviously, the higher one’s state and local taxes, the greater the importance of this deduction. This is why opposition to limiting this deduction is strongest in states with high state and local taxes. Politically, those are almost exclusively high-income blue states — New York, New Jersey, Connecticut, California, etc.
The New York Times has editorialized that the deduction should be maintained, even for high-income earners, who receive the greatest tax savings from it. New York City Mayor Michael R. Bloomberg wrote in the Daily News that it should be preserved. These positions are derived largely from self-interest, not based on any sound fiscal principles.
One effect of the deduction is that it encourages an increase in the size of state and local government because the costs of that additional government are partially borne by taxpayers elsewhere. If I told you the guy sitting at the restaurant table next to you will pick up 25 percent of the cost of dessert, you are more likely to get dessert.
The relevant question from a national perspective is whether the deduction is justified from a sound income-tax perspective or because of any positive spillover effects from the additional state and local spending.
From a pure income-tax perspective, there is little justification for the deduction. If state and local taxes simply are the price one pays for the benefits received from state and local government, then a deduction for payment of state and local taxes is no more defensible than a deduction for the cost of a new iPhone. To the extent that taxpayers are paying state and local taxes in excess of the benefits received from state and local services, one could argue that the deduction is legitimate on the grounds that the excess taxation is theft (which is deductible). Somehow, I doubt that is what The New York Times, Mr. Bloomberg and other blue-state defenders of the deduction think.
If the additional state and local government services that are induced by the deduction have positive spillover effects for the rest of the country, then it’s possible to justify the federal deduction on the grounds that those state and local services would be too few without the deduction. Even if that’s the case, the federal government could better target those services possessing positive spillover effects with direct outlays or grants to states and localities instead of using a deduction that broadly encourages more state and local government spending regardless of its spillover effects.
Under the current system, states and localities have an incentive to overproduce certain services that otherwise would be provided by the private sector. For example, suppose trash service can be provided by a local government and financed by local taxes, or it can be provided by a local, private free market. Even if the free-market solution led to more efficient service and a lower pre-tax price, taxpayers would be able to deduct the trash service only if it was provided by local government via tax dollars. The deduction thereby creates a distortion in favoring government provision of local services as opposed to a free market.
One argument in defense of the deduction is that it protects income-redistribution programs at the state and local levels. For example, in states with highly progressive tax systems and generous transfer programs (mostly blue states) the deduction mitigates the incentive for high-income earners to migrate to another state with less redistribution. This implicitly says one of two things: Either the state-level redistribution is not benefiting the high-income taxpayers living in the same state, or the state-level redistribution benefits everyone nationally, regardless of location.
While this is one of the better arguments in favor of the deduction, it is one that contradicts much of what supporters of higher state and local taxes often claim: that taxes don’t matter when it comes to people choosing where to live. Furthermore, the federal government already heavily supports state-level redistribution programs such as Medicaid, thereby limiting this free-rider problem.
Overall, as with any tax-reform question, our nation is best served by having a serious discussion of the pros and cons of the state and local deduction from a national perspective. It should not be negated from scrutiny merely because it has been around forever or because it affects certain constituencies more than others. The tyranny of the status quo that defends our ridiculous tax code must stop.
Gerald Prante is assistant professor of economics at Lynchburg College.