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The Effects of Converting the State and Local Tax Deduction into a Credit

By: Kyle Pomerleau

Over the past couple of years, the state and local taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. deduction has been a popular base broadener for the GOP. Nearly all GOP tax reform proposals from Congress and presidential campaigns since 2014 have included eliminating or limiting the deduction to pay for lower statutory tax rates.

Under current law, individuals who itemize can deduct the income or sales taxA sales tax is levied on retail sales of goods and services and, ideally, should apply to all final consumption with few exemptions. Many governments exempt goods like groceries; base broadening, such as including groceries, could keep rates lower. A sales tax should exempt business-to-business transactions which, when taxed, cause tax pyramiding. es they pay to state and local governments from their federal taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. . They are also able to deduct their state and local property taxA property tax is primarily levied on immovable property like land and buildings, as well as on tangible personal property that is movable, like vehicles and equipment. Property taxes are the single largest source of state and local revenue in the U.S. and help fund schools, roads, police, and other services. es. The state and local tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions. is one of the three largest itemized deductionItemized deductions allow individuals to subtract designated expenses from their taxable income and can be claimed in lieu of the standard deduction. Itemized deductions include those for state and local taxes, charitable contributions, and mortgage interest. An estimated 13.7 percent of filers itemized in 2019, most being high-income taxpayers. s (the other two being the home mortgage interest deductionThe mortgage interest deduction is an itemized deduction for interest paid on home mortgages. It reduces households’ taxable incomes and, consequently, their total taxes paid. The Tax Cuts and Jobs Act reduced the amount of principal and limited the types of loans that qualify for the deduction. and the charitable contribution deduction). According to the IRS, $520 billion in state and local taxes were deducted in 2014; 46.5 percent of state and local taxes were deducted by taxpayers with adjusted gross income over $200,000.

Eliminating the state and local tax deduction would be a significant base broadener. We estimate that eliminating the deduction relative to current law would raise $1.9 trillion over the next decade (see Table 1, below). It is the single largest individual income tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. broadener in the House GOP Blueprint and funds most of the plan’s individual rate reductions.

Although eliminating the state and local tax deduction is a centerpiece of GOP income tax reform efforts, some Republican lawmakers from higher-tax, higher-income states such as New Jersey, California, and New York have expressed concern. They worry that outright elimination of the deduction would mean that their constituents could end up paying more in income taxes.

To address this potential concern, Rep. Tom Reed, a Republican from New York, is rumored to be working on a proposal to preserve the tax benefit for state and local taxes paid by converting the deduction into a credit.

No details exist for this proposal, but one way to implement this would be to convert the state and local tax deduction into a 15 percent nonrefundable credit for state and local taxes paid. The idea behind converting the state and local tax deduction to a credit is to expand the tax benefit to middle-income taxpayers who currently don’t receive it, while preserving and limiting it for high-income taxpayers who currently do.

Since this conversion redistributes the federal tax benefit for state and local taxes paid, rather than eliminating it, this proposal raises much less revenue than a straight repeal. We estimate that converting the deduction into a 15 percent credit for state and local taxes paid would raise $137 billion over a decade, relative to current law, which is less than one-tenth the revenue impact of a straight repeal of the state and local tax deduction (Table 1, below).

This conversion would indeed make the tax code more progressive by reducing taxes for middle-income taxpayers and raising taxes for high-income taxpayers. Replacing the state and local deduction with a 15 percent credit for state and local taxes paid would raise after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income. s for the bottom four quintiles by as much as 0.5 percent while reducing them for the top 1 percent by 1.1 percent (Table 2, below).

Full elimination of the state and local tax deduction (without any accompanying rate reductions) would also make the tax code more progressive, by raising taxes primarily on the top 20 percent. However, in contrast to a 15 percent credit, full elimination (without any accompanying rate reductions) would slightly raise taxes on middle-income taxpayers.

Source: Tax Foundation Taxes and Growth Model, March 2017
  Relative to Current Law Relative to GOP Blueprint
Table 1. Revenue Impact of Changes to the State and Local Tax Deduction, Billions of Dollars 2017-2026
Full Repeal $1,901 N/A (Already Eliminated)
15 Percent Credit $137 -$1,687

As stated above, the House GOP Blueprint starts with the assumption that the state and local tax deduction would be eliminated. Converting the state and local tax deduction into a 15 percent credit as part of tax reform would essentially add back to the Blueprint a tax benefit for state and local taxes paid.

We estimate that if lawmakers were to add a 15 percent credit back to the GOP Blueprint for state and local taxes paid, this change would reduce federal revenue by $1.7 trillion over the next decade. In fact, the revenue impact of this would almost completely reverse the revenue gains from eliminating the state and local tax deduction.

Lawmakers could limit the generosity and the cost of the credit by providing a smaller credit or by phasing it out for high-income taxpayers. However, since GOP tax reform proposals start with the assumption that there would be no federal tax benefit for state and local taxes paid, a credit of any size would reduce revenue relative to a GOP reform baseline. This presents a potential challenge for reformers given that Republican lawmakers want to reduce statutory tax rates significantly.

Tax Foundation, Taxes and Growth Model March 2017 version)
Income Group 15 Percent Credit Full Repeal
Table 2. Distributional Impact of Changes to the State and Local Income Tax Deduction (Percent Changes in After-Tax Incomes, Relative to Current Law)
0% to 20% 0.0% 0.0%
20% to 40% 0.1% -0.1%
40% to 60% 0.4% -0.3%
60% to 80% 0.5% -0.7%
80% to 100% -0.5% -2.1%
80% to 90% 0.2% -1.3%
90% to 95% -0.1% -1.8%
95% to 99% -0.7% -2.5%
99% to 100% -1.1% -2.8%
 TOTAL -0.1% -1.4%