Eliminate the Deduction for State and Local Taxes

In determining their taxable income, taxpayers may choose the standard deduction when they file their tax returns, or they may itemize and deduct certain expenses (including state and local taxes on income, real estate, and personal property) from their adjusted gross income, or AGI. (AGI includes income from all sources not specifically excluded by the tax code, minus certain deductions.) Under the American Jobs Creation Act of 2004, taxpayers who itemized could opt to deduct state and local sales taxes, which previously had not been deductible, instead of state and local income taxes. The American Taxpayer Relief Act of 2012 extended that provision but only through 2013. Beginning in 2013, the total value of certain itemized deductions—including the deduction for state and local taxes—is reduced if the taxpayer’s AGI is above a specified threshold.

This option would eliminate the deductibility of state and local tax payments, a change that would increase federal revenues by $954 billion from 2014 through 2023, the staff of the Joint Committee on Taxation estimates.

The deduction for state and local taxes is effectively a federal subsidy to state and local governments; that means the federal government essentially pays a share of people’s state and local taxes. Therefore, the deduction indirectly finances spending by those governments at the expense of other uses of federal revenues. This option would take away the incentive that the current subsidy provides for state and local government spending, although some research indicates that total state and local spending is not sensitive to that incentive.

An argument in favor of removing the deduction is that the federal government should not subsidize state and local governments through the tax deduction because state and local taxes are largely paid in return for services provided to the public. If that is the case, such taxes are analogous to spending on other types of consumption, which are nondeductible. Another argument is that the deduction largely benefits wealthier localities, where many taxpayers itemize, are in the upper income tax brackets, and enjoy more abundant state and local government services. Because the value of an additional dollar of itemized deductions increases with the marginal tax rate (the percentage of an additional dollar of income from labor or capital that is paid in federal taxes), the deductions are worth more to taxpayers in higher income tax brackets than they are to those in lower income brackets. Additionally, the deductibility of taxes could deter states and localities from financing services with nondeductible fees, which could be more efficient.

An argument against eliminating the current deduction involves the equity of the tax system as a whole. A person who must pay relatively high state and local taxes has less money with which to pay federal taxes than does someone with the same total income and smaller state and local tax bills. The validity of that argument, however, depends at least in part on whether people who pay higher state and local taxes also benefit more from goods and services provided by states and localities.