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

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

Under current law if a taxpayer 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 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 taxes 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 tax. 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 tax base. Any income would only be taxed once either at the business level or at the individual level. Double taxation of saving and investment, such as the corporate income tax + capital gains and dividends taxes, would no longer exist.

There are several ways to have a consumption tax base: a value-added tax, a retail sales tax, a flat tax, 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.