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Is a Deduction for State and Local Income and Sales Taxes Paid Good Tax Policy?

By: Kyle Pomerleau

Representative Stephen Lee Fincher (R-TN) introduced a bill that would permanently extend the state and local general sales 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. . This deduction is part of the “extenders package” and expired at the end of 2013.

Under current law if a 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. payer itemizes, they are able to deduct the income taxes they paid to state and local governments. For instance, if a taxpayer had an AGI of $70,000 and paid $1,000 in taxes to their state and local governments (sales or income), they could deduct that from their AGI. Thus their 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. would be $69,000.

The ability to deduct state and local income taxes has existed since the inception of the federal income tax. However, the deduction for state and local 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 paid has only existed since 2006. This provision was introduced as a way to provide the deduction to taxpayers who lived in states with no individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. . Tennessee, Rep. Fincher’s home state, is one of those states with no income tax, but high sales taxes.

The state and local income and sales tax deductions are interesting tax provisions. Whether we want to get rid of them or keep them depends on what direction you see tax reform going.

In an ideal world, tax reform would move the U.S. tax system towards a neutral, consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. base. Any income would only be taxed once either at the business level or at the individual level. Double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. of saving and investment, such as the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. + capital gains and dividends taxes, would no longer exist.

There are several ways to have a consumption 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. : a value-added tax, a retail sales tax, a flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. , or a personal expenditure tax. They all only have one level of taxation and are neutral between consumption and saving, but they all define the tax base a little differently. How you define your tax base determines whether you need a deduction for state and local taxes.

Take a flat tax vs. a personal expenditure tax:

Under a personal expenditure tax, there would be a state and local income and sales tax deduction. People’s taxable income would be defined as income from wages, investments (capital gains and dividends), and transfer payments minus any net savings (deposits into savings accounts or stock purchases), educational expenses, and transfers to other people. Under this system, taxes paid to state and local governments would be treated as transfers to others, who would end up paying taxes on any benefits they receive from state and local governments. So in order to only tax this income once, the taxes paid to state and local governments would be deductible.

Under a flat tax, such as the Hall-Rabushka Flat Tax, there would be no state and local income and sales tax deduction. This tax base would define income for an individual as just wage income with essentially no deductions. And unlike the personal expenditure tax, investment and transfer income is not taxable. As a result, you would not be able to deduct your state and local taxes, to make sure this economic activity is taxed once.

So is this $51.8 billion a year tax expenditure good policy? It depends on where you are going.