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Case Study #4: The Deduction of State and Local Income Taxes or General Sales Taxes

4 min readBy: Michael Schuyler, Stephen J. Entin

Download (PDF) Fiscal Fact No. 382: Case Study #4: The Deduction of State and Local Income Taxes or General Sales Taxes

These results are part of an eleven-part series, The Economics of the Blank Slate, created to discuss the economic effects of repealing various individual 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. expenditures. In these reports, Tax Foundation economists use our macroeconomic model to answer two questions lawmakers are considering:

  1. What effect does eliminating these expenditures have on GDP, jobs, and federal revenue?
  2. What would be the effect on GDP, jobs, and federal revenue if the static savings were used to finance tax cuts on a revenue neutral basis?

For an overview of the project, click here. For links to articles from the rest of the series, click here.

Key Points:

Eliminating the deduction for state and local income taxes or general 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. es would:

  • Increase tax revenues by $67.7 billion on a static basis;
  • Reduce GDP by $74 billion;
  • Generate slightly less revenues ($50 billion) on a dynamic basis;
  • Reduce employment by the equivalent of approximately 251,000 full-time workers; and
  • Reduce hourly wages by 0.3 percent.

Eliminating the deduction and trading the static revenue gains for individual rate cuts would:

  • Allow for an across-the-board rate cut of 5.8 percent;
  • Boost GDP by $24 billion per year;
  • Boost federal revenues by $6 billion on a dynamic basis;
  • Increase employment by the equivalent of approximately 300,000 full-time workers; and
  • Reduce hourly wages by 0.1 percent.

The federal individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. code permits taxpayers who itemize to claim a deduction for their state and local income taxes or general sales taxes. However, the deduction is controversial. Two common criticisms are that it is mostly claimed by upper-income taxpayers, and that it softens people's opposition to high taxes and wasteful spending by state and local governments because some of those taxes can be written off at the federal level. Two defenses of the deduction are that it better measures people's incomes, recognizing that some of their income has been transferred to others, and that it provides state and local governments with an indirect subsidy that helps them to fund their operations. Nevertheless, the purpose of this case study is not to discuss the merits or demerits of the deduction but is simply to examine the growth effects if the deduction were repealed.

In a conventional static revenue estimate that holds the size of the economy fixed, the Tax Foundation's simulation model estimates that abolishing the federal income 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. for state and local income taxes or general sales taxes would have raised federal revenue by $68 billion in 2012. (See Chart 1.) This is higher than the Joint Committee on Taxation's estimate of $43.5 billion ($50.3 billion in 2013); it is unclear whether the gap occurs because the models differ in their structures, or because the JCT either has access to a larger and more complete tax sample that is not publicly available or has a different estimate of the growth of state and local taxes in recent years.[1]

When the unrealistic static assumption is relaxed, our model predicts that ending the deduction would cause some economic harm. Losing the deduction would push some people into higher 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, and the people affected would respond to the heftier marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. s by working and investing less. The model estimates that when the economy has fully adjusted, GDP would be $74 billion lower than otherwise. Because of the negative economic feedback, the estimate of the dynamic revenue gain would be smaller than the static estimate but still appreciable at $50 billion.

If the story ended here, the outcome would be mixed: ending the deduction would produce a sizeable federal revenue gain, but for every added federal dollar, the total size of the economy would contract by more than a dollar. However, if the revenue gain were used to finance an across-the-board federal income tax rate cut, the model predicts that the economy and federal receipts would both grow modestly.[2] This can be seen in Chart 2, above. The model estimates that if the entire conventional revenue estimate were directed into a 5.8 percent across-the-board rate cut, GDP would expand by a net $24 billion and federal tax collections would increase by a net $6 billion. From a growth perspective, this is an attractive trade.

Finally, we determined the impact of these scenarios on employment and wages. We found that the elimination of the state and local income tax deduction would reduce employment by the equivalent of about 251,000 full-time workers and cut hourly wages by 0.3 percent. With the rate cut offset, employment would increase by the equivalent of about 300,000 full-time workers and hourly wages would fall by 0.1 percent.

[1] The difference in the estimated size of the deduction would affect the level but not the pattern of the economic results of the Tax Foundation model runs.

[2] We assume proportional cuts in all of the ordinary income tax bracket rates but no cuts in the lower tax rates on capital gains and qualified dividends.