Elimination of State and Local Tax Deduction Possible

September 23, 2013

Reuters reports that the Ways and Means Committee plans to include limits to the state and local taxes paid deductions as part of the tax code overhaul.

“The deduction will be significantly curtailed or axed in any proposal put forward by Camp, said an aide who works for him,” according to the Reuters article.

We have weighed in on the issue of federal deductions of state and local tax previously. This past spring, Scott Hodge, the Tax Foundation president, testified before the Ways and Means Committee that the state and local tax deductions have the ability to influence the behavior of state and local governments:

“In the same way that the mortgage interest deduction may encourage some families to purchase a much larger home than they otherwise could afford, the taxes-paid deduction and the municipal bond exemption encourage many states to tax more, spend more, and borrow more than they otherwise would.”

In his testimony, he compiled a list of the key effects these provision have on state and local government. The evidence suggests the state and local tax provisions in the federal tax code:

  • Increase state reliance on deductible taxes;
  • Lead to higher state and local tax burdens;
  • Encourage higher state and local spending;
  • Encourage higher state and local debt; and
  • Disproportionately benefit high-income states and high-income taxpayers at the expense of low-income states and low-income taxpayers.

The chart below shows that states with the highest amount of taxes-paid deductions also have significantly higher levels of state and local government spending. In addition, 55 percent of the benefits from the state and local income, sales, and personal property tax deductions accrue to taxpayers with incomes above $200,000.

Furthermore, our Taxes and Growth Model finds that if Congress were to eliminate all state and local provisions in the federal code and use the revenue to cut rates across the board we would see a $41.2 billion increase in GDP.

More recently, we took a look at the economic effects of eliminating just the deduction for state and local income or general sales. We found that eliminating just this provision and using the revenue to cut taxes to maintain revenue neutrality would increase GDP by $24.4 billion and add the equivalent of 300,000 jobs.

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