Should Organizations Favoring Lower Taxes Embrace the Federal State and Local Tax Deduction?

January 6, 2009

So the National Taxpayers Union (NTU) wrote a letter to Tennessee congresswoman Marsha Blackburn in support of her proposal that would allow taxpayers to write off both state income taxes and state sales taxes on their federal income tax each year. In it, they use arguments that actually make the case against the state and local deduction.

Case 1:

By ending the “either/or” choice for itemizing income or sales taxes, H.R. 7308 would deliver significant savings to tens of millions of American families. For residents of the nine states that do not have a state income tax, the benefit would amount to $650 on average. In addition, it would be retroactive to the beginning of this year, ensuring that nobody misses out on the benefit when next Tax Day comes.

Actually, by ending the “either/or” those nine states benefit the least because right now, they get to claim the sales tax deduction and the income tax deduction is worthless to them. Only those states that have both an income tax and a sales tax would benefit from changing from the “either/or” policy to a policy of having both an income tax and a sales tax. (And as to why Marsha Blackburn would favor this policy, it’s totally bizarre. Relative to the current policy of an “either/or,” this proposal would make everyone in Tennessee worse off. That is unless it leads Tennessee to an income tax, which would mean government would grow and thereby benefit some in Tennessee, but not NTU and its members.)

Case 2:

H.R. 7308 would also eliminate for good a discriminatory portion of the Tax Code that has for many years penalized taxpayers who pay large state sales taxes. There is no legitimate justification for doing so on policy grounds, since sales taxes deprive citizens of their own money just as income and property taxes can. Indeed, federal law in this area can be said to provide cover for state leaders who unwisely raise economically destructive income taxes. According to a 2008 study of state and local tax burdens among 50 of America’s large cities, 7 of the 10 areas with the lowest overall tax burdens levied no income taxes at all. Meanwhile, 7 of the 10 areas with the highest overall taxes had income tax burdens that were above the national median. Taxpayers deserve a more rational Tax Code that doesn’t stack the deck against one particular state taxation scheme.

NTU sees this as ending a bias against the sales tax in states, which is true in most states. But for those states that have no income tax, it would actually encourage them to institute one. The main problem with NTU’s argument is that such a policy would encourage an overall increase in the level of state and local taxes because the federal government (i.e. taxpayers elsewhere) would be picking up an even greater part of the tab. Ceteris paribus, the deduction actually redistributes from those in low-tax locations to those in high-tax locations, and it actually discourages people from moving to low-tax areas.

Furthermore, it encourages government to be the producer of what would otherwise be private functions. For example, suppose you have a local government deciding whether to provide trash service or to have private companies compete. The government monopoly is inefficient and would charge people $30 per month, whereas the private market would only charge people $25 per month. But suppose everyone in the locality is in the 25 percent tax bracket and itemizes, the net cost of doing it through the government would now be $22.50. So basically, the rest of the country would have to pay for that locality’s citizens to have inefficient trash service.

While sales taxes may deprive citizens of their own money, they do receive government services in return. In theory, the amount deductible should only be that portion of the taxes paid that are theft (i.e. taxes exceed the value of the services rendered), and under a consumption tax, those that are for investment purposes. And in the United States, given the choice of 51 different states and thousands of localities, how much at the state and local level can really be theft until people start to vote with their feet?

You can learn a lot about a policy by looking at who supports it. AFSCME, whose mission is to grow government at the state and local level, has long supported this deduction. Why? Because it leads to bigger government at the state and local level.

In summary, there is a danger in favoring every policy that reduces one’s legal tax liability. That view is one of the reasons our health care system has the problems it does today, and it is why the tax code is so complicated.

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