High-Tax States are Inconsistent on the State and Local Tax Deduction

December 12, 2017

If the state and local tax deduction is necessary to prevent double taxation, why don’t states offer a deduction for federal and local taxes?

Representatives of several high-tax states, most notably New York and California, have excoriated the possible repeal or diminution of the state and local tax deduction as an assault on their states. The provision, which subsidizes high-income, high-tax jurisdictions, would be limited under the tax reform bill, with both the House and the Senate limiting the deduction to property taxes and capping its value at $10,000.

Opponents of the provision only occasionally delve into the thorny question of whether there is any justification for current law. When they do, the arguments typically boil down to concerns about double taxation, the idea that the deduction is necessary to avoid the federal government imposing a tax upon a tax.

But if that concern is genuine, then states need to step up as well. If the federal government taxing gross income, including the amount forgone in state and local taxes, is a tax upon a tax, then what exactly should we call it when states tax gross income, including the amount forgone in federal and local taxes?

The key, of course, is in the term itself: gross income, or more accurately adjusted gross income, which does include certain exemptions and deductions, but is meant to capture both saved and consumed income. Whereas corporate income taxes are imposed on net—which is to say, on profits—individual income taxes fall on gross income. You don’t get to deduct the cost of housing, food, clothing, or transportation, even though all those are important and make claims upon your income.

Many states, including New York and California, conform to federal treatment of the property tax deduction. However, most disallow the income tax deduction without any sort of subtraction for local income taxes, and they decidedly do not permit a deduction for federal income taxes paid. Only six states do that, and three of them cap the benefit.

There’s nothing wrong with this, of course. As we’ve noted before, in a federal system, individuals receive services from federal, state, and municipal governments. Each layer of government can be viewed as providing its own package of services, which one would expect to be “priced” separately.

When two taxes levied by a single government, or similar types of governments (for instance, multiple states), fall disproportionately upon the same income or economic activity, this represents a clear case of double taxation. When different levels of government levy taxes for discrete sets of services, the rationale for a deduction for taxes paid is far weaker.

Still, what’s good for the goose is good for the gander. If elected officials from New York and California believe that the federal government shouldn’t tax the share of income expended on state and local income taxes, shouldn’t they be equally concerned that their states tax the share of income expended on federal and local taxes?

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