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The Impact of Repealing State and Local Tax Deductibility
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© TAX ANALYSTS. Reprinted with permission.
Note: This report is available in its entirety in the Portable Document Format (PDF).
When President Bush convened a panel in 2005 to consider options for federal tax reform, he listed several goals, including tax simplification in a revenue-neutral way to promote long-term growth. He wanted the reform to maintain the progressivity of the income tax and incentives for homeownership and charity.
An important key provision not explicitly protected is the federal deductibility of state and local (income, general sales, and property) taxes, which is expected to have a tax expenditure cost of $65.8 billion in fiscal 2005 (as compared with $72.6 billion for home mortgage interest and $34.2 billion for individual charitable contributions).1
An additional impetus for tax reform is the individual alternative minimum tax. Although only 4 percent of taxpayers will owe AMT in 2005 because of a temporary provision that protects most middle-ncome taxpayers, 20 percent will become AMT taxpayers in 2006 after that provision expires. By 2010, almost one-third of taxpayers will owe AMT. The largest AMT preference item that is, a deduction allowed under the regular income tax but not the AMT is the deduction for state and local taxes. Therefore, as the AMT net widens, more households will get little or no benefit from the state and local tax deduction. In light of that, one possible reform could be the repeal of state and local tax deductibility from federal income taxes in conjunction with the repeal or reform of the AMT.2
Before reforms to federal policy are undertaken, it is important to understand the possible ramifications to subnational governments and to understand the theoretical justification for tax deductibility. There are concerns that the removal of state and local tax deductibility will lower support for public services and lead to a "race to the bottom" in terms of state and local expenditures as states compete to have the lowest taxes in order to attract higher-income households. The likelihood of that scenario depends on what factors affect the location decisions of households and how large the expected increase in tax liability is expected to be for households with different income levels.
This report will briefly discuss the history and arguments for and against the deductibility of state and local taxes. It presents some summary information on the distribution of state and local tax deductions and explores what factors will affect the future costs of repeal, focusing on who currently benefits most from those deductions across different states and income levels. The report presents projections of the cost savings to the federal government if the state and local deductions were eliminated under scenarios both with and without the AMT being repealed, and explores which groups of taxpayers are expected to see changes in their tax bills over time. The report returns to the question of how that is expected to affect state and local governments, examining current estimates of the subsidy rate that tax deductibility gives to state and local governments and drawing lessons from the aftermath of the Tax Reform Act of 1986. The interaction with the AMT lessens the impact of repeal for many households, thus the effect on states and the question of whether the elimination of state and local tax deductibility will lead to a race to the bottom rests on the influence and mobility of the wealthiest taxpayers.
Notes from this section
1 Tax expenditures are taken from the Congressional Research Service (2004).