- The Washington Times - Tuesday, November 23, 2004

President Bush reportedly is considering an end to the deduction for state and local taxes as part of tax reform.

While defensible tax policy, I don’t think he realizes just how extraordinarily difficult that would be. Unless it is combined with something incredibly popular that Congress is forced to accept as a package deal, I see little likelihood of enactment.

In 1984, President Reagan asked the Treasury Department to study tax reform. It recommended eliminating the deduction for state and local taxes mainly on the grounds that it subsidized consumption through government.

As Treasury’s report explained: “The current deduction for state and local taxes in effect provides a federal subsidy for the public services provided by state and local governments, such as public education, road construction and repair, and sanitary services. When taxpayers acquire similar services by private purchase (for example, when taxpayers pay for water or sewer services), no deduction is allowed for the expenditure. Allowing a deduction for state and local taxes simply permits taxpayers to finance personal consumption expenditures with pretax dollars.”

When Mr. Reagan sent his tax reform proposal to Congress in May 1985, it emphasized fairness, saying the state and local taxes deduction mainly benefited high income earners and those in high-income states. Because there is a great loss of revenue, requiring higher federal tax rates, taxpayers with low incomes or in low-income states in effect subsidize the rich.

These are still valid arguments. The states that benefit most from the state and local deduction are those with the highest taxes, which generally are those with the highest per capita incomes. Because the top federal income tax rate is 35 percent, in effect the top state and local income tax rate is cut by 35 percent. A state rate of 10 percent is really only 6.5 percent when federal deductibility is taken into account.

This encourages higher state tax rates than might otherwise be adopted, with governments providing services the private sector might better be able to deliver and financing such services with deductible taxes rather than possibly more efficient nondeductible fees.

Low-tax states and those without income taxes in effect underwrite these larger governments and higher taxes.

The main argument against ending the deduction is that it would massively increase taxes on some states and would decimate their finances. Back in 1986, every political leader in the state of New York — then, as now, a very high-tax state—made this argument ad nauseam. New York Gov. Mario Cuomo was the No. 1 advocate of retaining the deduction.

Although the argument was usually overwrought, people like Mr. Cuomo had a point. If the state and local deduction constitutes a subsidy, its withdrawal will penalize those who make the most use of it. The point is to change governmental behavior by prompting state tax cuts, contracting out and privatizing state services, and shrinking the public sector.

The most principled argument for the state and local tax deduction is federalism — the federal government should not impos itself onto state and local tax decisions. That is why the state and local tax deduction was made part of the income tax when it first came into existence in 1913 and has since remained part of the tax code.

Conservative arguments against eliminating the state and local tax deduction include concerns states will switch from personal income taxes to businesses taxes, which would remain deductible as a business expense in any case. This could diminish economic growth. Also, it is said it is fundamentally unfair not to allow a deduction for taxes because they reduce taxpayers’ income and are something they cannot control.

Ultimately, the case for retaining the state and local tax deduction — or at least the combined lobbying pressure of the states and their Washington representatives — proved compelling and the deduction was retained in the Tax Reform Act of 1986. That same pressure will have to be overcome again if Mr. Bush plans to take another run at it.

One thing that may tilt the playing field a little more against the deduction this time is that the Alternative Minimum Tax has already heavily eroded it. For those who must pay the AMT, no deduction for state and local taxes is presently allowed. This is a key reason why those in high-tax states tend to pay more in federal taxes than they get back in federal spending.

Still, the political fight will be furious. It cannot hope to succeed unless the payoff is big enough to create a countervailing political force. I think only a low flat-rate tax with no deductions for anything has that potential.

Bruce Bartlett is senior fellow with the National Center for Policy Analysis and a nationally syndicated columnist.

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