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Responses to Questions from Senator Orrin Hatch on the Effect of Federal Tax Policy on the States

7 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 Baucus, Senator Snowe, and Senator Enzi.

Currently most 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. payers who itemize have the choice of deducting certain taxes paid to state and local municipalities. Currently deductions are allowed for state and local real property, personal property, state sales, and income taxes. The Joint Committee on Taxation estimates that the revenue loss to the Federal government from 2011 to 2015 of these deductions will be $347 billion, if it is extended for that time. As Mr. Sammartino notes, “By lowering the net cost of those state and local taxes, the taxes-paid deduction encourages state and local governments to impose higher taxes…” My question is, how much do these deductions subsidize state and local governments? We know what the revenue loss is to the federal government, but even if one is comfortable subsidizing state government, is this a good way to do it?

If the desire is to subsidize states with high state income taxes, it is effect at doing so. If the desire is to use federal funds to shift resources from high-income states to low-income states, 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. is a poor choice since it does precisely the opposite.

President Obama has proposed to dramatically reduce the charitable deduction in his latest budget, as well as previous budgets. He does so by proposing to take away up to 29% of itemized deductions for families that are in either of the top two income tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. s. This will reduce charitable giving. Charity should be the last thing that the President is attacking. The President is also going after the ability of families and individuals to exclude interest on tax-exempt bonds from their income. This question is for the whole panel. Yes or no—do you agree with me that the President’s proposal will increase borrowing costs for state and local governments? Please explain.

Yes. Remember however that states must make their bonds marketable to people in all tax brackets, so interest rates must be set in a way that will be attractive both to people in the 35 percent bracket and people in the 28 percent bracket. It therefore is possible that a 28 percent limitation on state-local bonds would result in no change in interest rates and state borrowing costs. I say yes, however, because it is likely that it will affect borrowing costs to some extent, as removing the tax exemptionA tax exemption excludes certain income, revenue, or even taxpayers from tax altogether. For example, nonprofits that fulfill certain requirements are granted tax-exempt status by the Internal Revenue Service (IRS), preventing them from having to pay income tax. means the bonds will lose a current key advantage and they will therefore be less valuable to their buyers absent higher interest.

Mr. Henchman, in your testimony you describe how a fundamental purpose of the Constitution was to prevent states from shifting tax burdens to out of state individuals and businesses. However, you also discuss it is not necessarily appropriate for Congress to become involved in state tax issues, even if the given state policy is bad. Could you expand on what you see as the legitimate use of Congress’ authority to regulate interstate commerce versus the ability of the states to engage in tax competition in order to attract individuals and businesses. At what point does a state’s tax policy transition from a threat to interstate commerce into an incentive for businesses from other states to leave or for people to move out? Do you think there is a danger of using tax policy at the federal level to accomplish non-tax policy objectives at the state level? For example, using tax policy to make a given activity prohibitively costly instead of prohibiting it outright?

Before Congress gets involved, 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.

There certainly is incredible risk in involving the federal government to achieve objectives at the state level. It should be done sparingly, to permit policy experimentation. I’m a believer in federalism, but when experimentation turns into expanding state authority beyond its borders and reaching people with no property or employees in the state, or punitive policies against those who direct investment away from the state, Congress should be wary.

Though many technological advancements have been made over the past several years, oftentimes government seems to lag behind the private sector in terms of taking advantage of these advancements. In your testimony you describe how difficult it is, even with “several staffers as well as computer-based and publication services” to keep up with changes to federal and state tax codes. Could you describe in more detail the nature of this difficulty, which I suspect is at least partly related to the fact the government does not have the same incentives as private enterprise to adapt to new technologies? How often do states make changes to their tax codes, and how effective do you think states are in alerting taxpayers to those changes?

States make changes continuously. Many state websites that announce these changes are inadequately updated, lag in time, or provide insufficient direction to answer questions. Services that follow tax changes are very lucrative because the complexity makes it impossible for any taxpayer to do it himself.

Some of this is due to slow adoption of technology, such as when a state posts a PDF that is not text-searchable instead of one that is. Some of it is just not prioritizing making information available. Some of it is motivated by deception, such as with California hiding the fact that its top personal income tax rate is one point higher than it claims.

Some of it – most of it, perhaps – is motivated by parochialism. 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.

There’s a reason lawyers have for the most part not been replaced computers. Lawyers can parse, analyze, analogize, and interpret. 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. law is much the same. Take this summary by my former colleague Josh Barro of a Wisconsin circular explaining the sales taxation of ice cream cakes:

Ice cream cake is a taxable prepared food if you make it yourself, but not if you’re just reselling the cake. However, if the cake contains real cake layers, it’s a non-taxable baked good no matter who made it, so long as the amount of cake exceeds the amount of ice cream. (No, really: Example 9 is a cake with two cake layers and one ice cream layer, which is tax exempt; Example 10 is a cake with one cake layer and two ice cream layers, which is taxable because it doesn’t contain enough cake.) If you buy a cake from someone and then decorate it yourself, it’s taxable no matter how much flour it contains. And if you slice any cake and serve it in individual servings, or if the cake consists of fewer than four servings, or if the customer is going to eat the cake on the premises at your business, or if you give the customer utensils with his cake, it’s a taxable prepared food, though you may be exempt from that last one if the sale of prepared foods is incidental to your business.

Computers might help with that, but the real problem is that the state law is unnecessarily complex and ambiguous.