'Blue states' could lose key deduction in tax reform

Author: Marilyn Geewax

Published: November 26, 2004

President Bush's "revenue-neutral" tax reform needs losers to balance its winners, and people claiming the federal deduction for state and local taxes may be in administration planners' sights, news reports say.

If true, that could leave the blue states seeing red.

In the past election, the states that collect the most income taxes were solidly "blue" supporters of Democratic challenger John Kerry.

Eight of the 10 states with the most revenue in 2000 voted for Kerry: California, New York, Pennsylvania, Massachusetts, Michigan, Illinois, New Jersey and Maryland. Only Ohio and North Carolina voted for President Bush.

The federal deduction for state and local income taxes "predominantly benefits the blue states," said William Gale, a tax policy expert at the Brookings Institution, a liberal-leaning research group. "There is definitely a political calculation to this."

But before conspiracy theorists get too carried away, political observers note that by eliminating deductions for state income taxes, Bush would be inflicting political pain on two of the nation's most prominent Republican governors, George Pataki of New York and Arnold Schwarzenegger of California.

And they'll be watching closely to see if Bush will also seek to end the federal deduction for property taxes.

That would spread the pain more widely, including to "red" Texas and Florida which collect little or no income tax, but rely heavily on property taxes.

However, it would rile real estate interests, one of the most powerful lobbies in Washington. And it would run counter to the "ownership society" Bush has invoked to justify tax cuts on stock dividends, interest payments and capital gains.

Moreover, wiping out the federal deduction for state and local income taxes could play havoc with a law passed just this fall.

As a sweetener to win passage of a huge corporate tax bill, lawmakers allowed residents of all 50 states to take a federal deduction for either state and local income taxes or for state sales taxes, whichever amount is higher.

Seven states are big gainers under the new law, because they have sales taxes but little or no income tax. Six of them ? Texas, Florida, Nevada, South Dakota, Tennessee and Wyoming ? voted for Bush. Washington is the only one in the group that went for Kerry.

Because residents of states dependent upon sales taxes haven't grown accustomed to taking the federal deduction, its quick disappearance might not generate much outrage.

But in the states that have long depended upon federal deductions to soften the blow of state income taxes, the change could have a serious impact. State legislatures that face budget deficits might be forced to cut services or shift to other sources of income, such as lotteries, because they would not able to muster political support for higher income taxes.

Losing the federal deduction would "effectively increase the price of state and local taxes" to people who itemize their tax returns, said Harley Duncan, executive director of the Federation of Tax Administrators, a group representing state tax officials.

As many as 40 percent of taxpayers do itemize, and they tend to be the people with bigger incomes, so they definitely would feel the tax increase if they lost that federal deduction, he said.

"From a practical effect, this would be a big deal" for states and their taxpayers, Duncan said.

Even though Bush has not revealed any specific tax proposals, opposition is likely to flare up quickly among states that rely heavily upon income taxes to finance services.

Molly Ramsdell, director of the Budgets and Revenue Standing Committee for the National Conference of State Legislatures, said the bipartisan group already "has publicly expressed strong support the federal deduction" for state income and sales taxes. "We will continue that position."

Before the end of this year, Bush is expected create an advisory panel to study tax reform options and make recommendations.

In his first term, Bush pushed for ? and won ? a tax cut in each of the four years. His primary emphasis was on lowering rates for everyone who pays income tax.

But during his presidential campaign, he promised to use his second term to put an even greater emphasis on promoting an "ownership" agenda. "I believe strongly in ownership, because I know if you own something, you have a vital stake in the future of the United States of America," he said in a typical campaign comment last August.

To spur Americans to own shares of companies, Bush wants to further reduce taxes on dividends, interest and capital gains. He argues that by reducing taxes on investments, the government could help Americans become more financially secure, while creating new pools of capital to fund economic expansion and job creation.

Mark Bloomfield, president of the American Council for Capital Formation, said reducing taxes on investments could help states by spurring job creation. "You would have higher levels of economic growth," which could lead to new tax revenues, he said.

Critics say that shifting taxes away from investments would increase the burden on wage-earners. People rich enough to live off investments would gain, while workers would lose deductions for state and local taxes.

The president's tax advisory panel is expected to take roughly six months to make its recommendations. Treasury Secretary John Snow would then review their proposals and develop a plan for the administration to propose to Congress. The goal would be to have the changes enacted before the congressional election campaign in the fall of 2006.