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State and Local Tax Policy: How does the deduction for state and local taxes work?

Taxpayers who itemize deductions may subtract general state and local taxes in calculating their federal taxable income. They may deduct either income or sales taxes they have paid (that choice expires, however, after 2007) as well as property and certain other taxes. Virtually all of the 48 million households who itemized in 2005 claimed a deduction for state and local taxes paid; these deductions totaled $420 billion. The state and local tax deduction cost an estimated $50.7 billion in tax expenditures in fiscal 2007, compared with $73.7 billion for the home mortgage interest deduction and $41.9 billion for the individual charitable contributions deduction.

  • State and local taxes have been deductible since the inception of the federal income tax in 1913, when all taxes (including federal, state, and local taxes not directly tied to a benefit) were deductible against federal income. By 1964 deductible taxes had been limited to state and local taxes on real and personal property, income, general sales, and motor fuel sales. The deduction for taxes on motor fuel was eliminated in 1978. The Tax Reform Act of 1986 eliminated the deduction for general sales tax; this deduction was partially and temporarily reinstated in 2004.
  • From 2004 to 2007, itemizers could elect to deduct state and local sales taxes in lieu of deducting state and local income taxes. About 73 percent of itemizers deducted income taxes in 2005, while 23 percent-mostly in states without a general state income tax-chose to deduct sales taxes. About 86 percent of itemizers deducted real estate taxes.
  • Although taxpayers in all states claim the deduction, the benefits are concentrated in relatively few states: those with a disproportionate share of high-income households and relatively high state and local taxes. In 2005, taxpayers in California and New York together made up 20 percent of those claiming the deduction and accounted for 30 percent of its value. Itemizers in New York, New Jersey, Connecticut, and California (listed in descending order of the average deduction) claimed on average over $12,000 per household (see figure), well above the national average deduction of $8,764 per household.
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  • The alternative minimum tax (AMT) scales back or eliminates the benefit from deducting state and local taxes for some taxpayers. The deduction is the largest single AMT preference item (a deduction allowed under the regular income tax but not under the AMT): it accounted for more than 60 percent of the dollar value of all preferences in 2005. Virtually all AMT taxpayers lost at least some of the deduction that year.
  • Critics of the deduction argue that state and local taxes simply reflect payments for services provided by state and local governments and, as such, should be treated no differently from other forms of consumption. Moreover, the deduction most benefits the affluent: the 11 percent of taxpayers with incomes exceeding $100,000 claimed nearly 60 percent of the value of deductions in 2005.
  • Proponents of the deduction counter that the portion of an individual’s income claimed by a state or local government is not really part of the individual’s disposable income and that taxing it is double taxation. The deduction also may encourage higher-income taxpayers to support state programs that primarily benefit lower- and middle-income households.
  • Eliminating the deduction would increase federal tax receipts by about $40 billion in 2008 and about $750 billion between 2008 and 2017 (less if Congress extends the 2001-06 income tax rate cuts beyond their scheduled 2011 expiration). Elimination could be coupled with repeal of the AMT; the revenue gain from the former could help offset the fall in revenue from the latter. Eliminating both would cut revenue by $2 billion in 2008 but would increase revenue by $340 billion over ten years.
  • Because many fewer taxpayers pay the AMT than benefit from the deduction of state and local taxes, repealing both provisions would cause many more households to pay more taxes than to pay less: taxes in 2007 would have increased for 22 percent of households and fallen for only 11 percent, and the average federal income tax bill would have risen nearly $100. Most taxpayers with income between $200,000 and $500,000 would have gained, because most of them pay AMT: nearly three-fifths of them would have paid less tax. Losers would outnumber winners in all other income categories.
  • The deduction indirectly subsidizes state and local governments. Evidence on how they would respond to its elimination is limited. Estimates based on 1995 data of the effect on the tax price-the net cost to taxpayers of financing an additional dollar of state and local spending-suggest that eliminating the deduction would lead to an average increase of 8.5 percent, varying across states from less than 1 percent in Wyoming to 10 percent in Maryland. After the Tax Reform Act of 1986 eliminated the deductibility of state and local sales tax, however, the amount of state and local tax revenue coming from the sales tax changed little. Limited evidence also suggests that eliminating the deduction would induce some high-income households to move from higher-tax areas to lower-tax areas.
 
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