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Responses to Questions from Senator Max Baucus on the Effect of Federal Tax Policy on the States

5 min readBy: Joseph Bishop-Henchman

These questions related to this testimony to the U.S. Senate Finance Committee. See related answers to questions from Senator Snowe, Senator Hatch, and Senator Enzi.

Currently, 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. laws provide a deduction for State and local taxes. Should these deductions be eliminated or limited as part of tax reform? Why or why not? What’s the benefit to the federal government for these provisions being a part of the federal tax system? Is it fair that only taxpayers that itemize their deductions get the benefit of the deduction for State and local taxes?

Nationally, in 2009, about 25 percent of taxpayers took the state-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 and local taxes paid, mortgage interest, and charitable contributions. , although the percentage is much higher in states with high income taxes. (In Maryland, for instance, 46 percent of taxpayers take the deduction.) As you note, only the minority of taxpayers who itemize can take the deduction.

The 1986 tax reform effort at one point considered elimination or limitation of the state and local tax deduction, which was scotched primarily due to strong resistance from New York officials, the Conference of Mayors, and public employee unions. These groups strongly opposed any limitation on the deduction and were ultimately successful in preventing any change to it. These interests likely remain just as strong today. They assert that it is double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. for money paid in federal tax to also be subject to state tax.

That said, the economic consensus is that the state and local tax deduction operates as an unjustifiable subsidy that makes higher-tax states (such as New York) more palatable. In the absence of the credit, these states may face pressure to reduce state-local tax rates and burdens to remain economically competitive. This explains these states’ strong resistance to any limitation on the credit.

Why has it been so difficult for the states to reach agreement on the details of the Streamlined Sales and Use Tax Agreement? Why have more states not joined? Isn’t it in the states’ best interests to simplify their 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. regimes so that they can require remote sellers to collect sales taxes? How would you compare the work trying to reach consensus on the Streamlined Sales and Use Tax Agreement with that on the International Fuel Tax Agreement which was originally worked out by the states?

My personal opinion is that states are reluctant to give up parochial tax preferences that they perceive to be in their favor, and face no compulsion or threat of compulsion that would motivate them to do so. SSTP long ago gave up on any simplification effort, preferring to focus on uniformity. They have consequently enshrined a number of complicated tax practices, such as differential taxes for different food products and clothing items, temporary sales tax holidayA sales tax holiday is a period of time when selected goods are exempted from state (and sometimes local) sales taxes. Such holidays have become an annual event in many states, with exemptions for such targeted products as back-to-school supplies, clothing, computers, hurricane preparedness supplies, and more. s, and sourcing rules.

As one example, most states have a “rounding rule” indicating that, as we learned in grade school, amounts left over must be rounded up or down: .5 or up is rounded up, .49999 or down is rounded down. Maryland law defies this, insisting that any leftover amount is rounded up. Maryland obviously perceives some benefit from this counterintuitive and disuniform rule although it’s beyond my comprehension. They also think that Congress isn’t going to make them do anything differently.

In 1959, Congress threatened to impose a uniform apportionmentApportionment is the determination of the percentage of a business’ profits subject to a given jurisdiction’s corporate income or other business taxes. U.S. states apportion business profits based on some combination of the percentage of company property, payroll, and sales located within their borders. rule. The states did not like the proposed rule, and the threat motivated them to get together and hammer out a uniform rule that had a consensus between states, industry, and taxpayers. Today, nothing similar is motivating states to compromise for the good of the national interest. They can defy and fight and drag their feet with no consequence. They also think they can collect from remote sellers without having to give up anything in return, as evidenced by the passage of “Amazon” tax laws in the states despite their negative policy effects. If Congress clarifies that point for states, more progress can be made.

What factors should Congress consider in determining whether state activity burdens interstate commerce? What simplicity requirements should be met before Congress determines that a state statute (or an agreement among states) doesn’t burden interstate commerce? How important is technology in determining whether a tax requirement burdens interstate commerce? How has technology changed what is considered simple or a burden?

These are particularly insightful questions, ones that we at the Tax Foundation will be investigating further in the months ahead. At its core, if we’re going to make every retailer in the world comply with a state sales tax, the retailer should be able to do so without a tax department or a tax expert. Filings should intuitive and streamlined into one form, rates should be accessible, definitions clear if there are differential rates, and clear answers to inquiries promptly given.

Technology can certainly make this easier, although much of the problem rests with wishy-washy definitions and the complications from 9,600 different jurisdictions taxing different things differently. Computers can’t solve that. Much of the same problems exist with our one federal tax code, and computers have helped with compliance but have not reduced complexity. Owning an iPad doesn’t make filling out income tax much easier.

As to what Congress should consider in determining whether state activity burdens interstate commerce, I would point to whether there is demonstrable evidence that economic activity is being misdirected across state lines due to punitive state tax policies on that activity (relative to wholly in-state activity with no interstate component, if it exists). That may not be dispositive but can strongly suggest problematic activity that Congress might consider curtailing through preemption legislation.