The State and Local Tax Deduction Could Be Turned On Its Head

Itemized deductions in the federal tax code allow filers to deduct taxes paid to state and local governments. A common objection to the deduction is that it benefits high-tax states at the expense of low-tax states. A state can raise money by hiking taxes and the federal government will partially soften the blow to its taxpayers, shifting the burden onto taxpayers in other states.

We published a map last year showing how much this deduction is used in different states; legislators from Alaska, South Dakota, Wyoming, and Texas might be concerned about how little the deduction benefits their constituents. All else equal, lowering state taxes increases the state’s share of the federal tax burden, which seems like an unintended consequence.

Nonetheless, there is an important purpose to the state and local tax deduction, and that is to define the tax base fairly. If there are two separate layers of income taxes with no deductions, then people end up paying tax on income they never even had a chance to receive.

If a future tax reform bill eliminates the state and local tax deduction, then states could handle the issue; they could offer a deduction for federal taxes minus credits, like a handful of states do already. While there is a legitimate case for avoiding the double tax, there is no reason the deduction has to be in federal tax returns. Putting it in state tax returns instead would eliminate the problem of burden shifting.