Federal Deduction for State Sales Taxes May Expire Soon

September 18, 2006

The federal income tax has traditionally allowed a deduction for state-level income taxes paid. Recently lawmakers also reinstated a deduction for state sales taxes paid as well. The provision had previously been eliminated as part of the 1986 tax reform, and was revived by Congress in 2004.

However, the federal sales tax deduction is only a temporary provision, and may expire soon if Congress doesn’t renew it by October 15th—a deadline set by the Internal Revenue Service for items to be included on next year’s tax forms. From Sunday’s Los Angeles Times:

Just about every lawmaker in Congress favors extending a batch of popular tax benefits approved during President Bush’s first years in office and authorized through 2005.

But in a case study of the tortuous process that can surround even the most highly regarded proposal on Capitol Hill, extension of the tax benefits appears to face an uphill road as Congress nears adjournment.

The benefits, claimed by more than 10 million taxpayers last year, give those who live in states without income taxes a deduction for their state sales taxes. They allow a deduction for some college tuition. Teachers may deduct the costs of buying supplies for their classrooms. And a research and development tax credit — hugely popular in the business community — is also part of the package.

But so far, these and 43 other tax benefits have become ensnared in a partisan battle over a minimum-wage increase, which Democrats and some moderate Republicans want, and a sharp reduction in the estate tax, dear to the hearts of conservative Republicans…

Some lawmakers, including at least one powerful Republican, are pushing for Congress to break the deadlock.

“Taxpayers could miss out on valuable benefits through no fault of theirs,” Sen. Charles E. Grassley (R-Iowa), chairman of the tax-writing Finance Committee, said last week. “I urge the House and Senate leadership, both Republican and Democrat, to take this problem seriously.”

Grassley warned that time is of the essence, saying that Internal Revenue Service officials have told him Congress must approve the benefits extensions by Oct. 15 if the changes are to be included in 2006 tax forms. That means Congress, which plans to adjourn at the end of this month to campaign for the November elections, has only two weeks to act. (Read the full piece here).

In the past, we’ve argued against the various credits, deductions and exemptions in the federal income tax code—including the deduction for state and local sales taxes—because they ultimately force up tax rates by shrinking the federal income tax base.

Here’s our section on the federal deductibility of state sales taxes, from our analysis of the final report of the President’s tax reform panel in November 2005:

Eliminate the deduction for state and local taxes Both plans would eliminate the current tax deduction for state and local taxes which removes more than $320 billion from the federal tax base. The estimated value of these deductions in 2006 are $49.4 billion. This proposal will expand the tax base and reduce the tax code’s complexity. The common critique of these deductions is that they partially subsidize state and local spending; therefore states and localities do not fully realize their true costs. Without the deduction, this distortion is removed. Lastly, some argue that the deduction eliminates double taxation of income; however, allowing the deduction gives a greater benefit to those who live in high tax states and localities. It is more economically neutral to eliminate the deduction than to allow some groups to benefit more than others. (Read the full piece here.)

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