September 9, 1985

Working Paper: Battle Over State/Local Tax Deductions High Income Tax Burdens II

Download Working Paper: Battle Over State/Local Tax Deductions High Income Tax Burdens II

There is growing opposition to the Reagan tax reform proposal to eliminate the personal deduction for state/local taxes. This proposal is particularly important to the overall reform plan because it would provide over 40 percent of all of the individual base-broadening measures (in dollar volume) or S40 to $46 billion by fiscal 1990. If the Provision is dropped or severely curtailed, the opportunity for reducing marginal rates obviously would be restricted, too, or some large new alternative revenue source would have to be developed. Needless to say, the latter would be extremely different.

While the Administration maintained a no-compromise position on removing the state/local tax deduction through the Spring and after releasing the Reagan I program, there is lots of talk in Congress of accommodating the critics of the proposal. Suggestions range from limiting the deduction by a dollar cap to retaining it for some state/local taxes and not others.

Unfortunately, most of the compromises being talked about do not make for sound tax policy. In this regard it is important to note the traditional justification for deductibility-that state/local taxes reduce income involuntarily and thus reduce ability to pay. This rationale was part of the original income tax structure going back to the Civil War. The deductions as a subsidy to taxpayers in high-tax states was a non-argument.

Over the years certain tax reformers have attacked the state/local tax deduction for eroding the progression of the income tax–it being of most value to upper-income taxpayers. Followers of the Haig-Simons school claim that state/local taxes are really payments for “consumer services”–schools, fire and police protection, local roads, etc.–of benefit to the taxpayer and, therefore, should not be excluded from a comprehensive income tax base.

If so, however, these are “services” over which individual taxpayers have very limited choice. In the Treasury I reform plan of November 1954, the theme of state/local taxes as consumer payments was picked up again but in a most convincing manner. Since then, justifying the elimination of the deduction has relied almost totally on the charge that the present deduction subsidizes taxpayers in high-tax state/localities relative to low-tax areas. In this writer’ s opinion, at least, nobody has come forth to date with a compelling case that state/local tax payment-which can amount to a very significant portion of a family budget-do not reduce ability to pay Federal income tax.

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