This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.
This week we’re looking at the IRS rule that allows taxpayers to deduct from their taxable income taxes paid to state and local governments. This tax break, the country’s fourth largest, is expected to cost Washington about $450 billion in forfeited revenue over the next five years.
What is the deduction for state and local taxes?
When you calculate how much income you had in the past year for the purpose of paying federal taxes, you can subtract the taxes you’ve paid to your state, city, or town. So if you earned $100,000 but $5,000 in state and local income taxes was withheld, you’re allowed to calculate your federal income tax bill as if you only earned $95,000.[1]
Why is it a “tax expenditure”?
Special tax breaks are considered “tax expenditures” because they are essentially government spending programs that give out tax breaks instead of direct payments.
The ability to deduct one’s state and local taxes may not intuitively strike us as a tax break, especially when compared with provisions that explicitly subsidize certain activities, like receiving health insurance from one’s employer or taking out a mortgage. But the deduction for state and local taxes is considered a tax expenditure by both of the government offices that track such expenditures: the Treasury Department’s Office of Tax Analysis and Congress’s Joint Committee on Taxation.
The rationale is that your state and local tax payments are essentially “purchasing” certain services—for example, police protection and public schools—and payments for personal services are generally not deductible. For example, the money you spend on personal house-cleaning services is not deductible, but the tax dollars you “spend” on municipal street-sweeping is.
The White House explains it this way in its budget: State and local taxes “pay for services that, if purchased directly by the taxpayer, would not be deductible.”[3] The federal tax deduction lowers the “price” of these services, according to the Congressional Research Service.[4]
Of course, taxpayers don’t make individual decisions to pay taxes. These are collective choices made through the democratic process. Families exercise some control over where they live but not over whether they pay taxes. In this sense, the measure of one’s income should not include amounts that are earned but then required to be paid over in taxes. And if these amounts are not income, then the deduction for them is not properly a special tax break. That’s why there is not universal agreement that this deduction is a “tax expenditure” in the first place.
Who benefits from this deduction?
Notwithstanding these theoretical issues, the state and local deduction has several practical effects. And as with all tax expenditures, the question of how the deduction works deserves greater scrutiny.
The deduction for state and local taxes disproportionately benefits high-income taxpayers, property owners, and residents of high-tax states. That’s because those groups pay the most taxes at the state and local level. It also benefits high-income taxpayers because any kind of deduction is worth more to people in high tax brackets than low tax brackets.[5]
The deduction is also a federal subsidy to state and local governments. When these governments tax their residents, they receive all of the resulting revenue. But the residents do not bear the full burden of state and local taxes, because those tax payments reduce their federal tax bill.
Because of this subsidy effect, the deduction can affect the fiscal choices made by states and communities, including the kinds of taxes they decide to levy. Before 2004, state and local sales taxes were not deductible. This provided some incentive for states to rely on income and property taxes, which tend to be progressive forms of taxation, rather than sales taxes, which tend to be regressive. But Congress just extended a provision, first enacted in 2004, that lets people deduct either income taxes or sales taxes. This provision benefits the residents of states like Florida and Washington, which have no individual income tax and rely heavily on sales taxes.
Like all tax expenditures, the deduction for state and local taxes has a significant cost to the federal government and deserves greater scrutiny.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions.
Next week: A closer look at the fifth-largest tax expenditure: the deduction for charitable contributions.
Endnotes
[1]. The state and local tax deduction is an “itemized” deduction, available to taxpayers who choose to deduct their itemized expenses rather than claim the standard deduction.
[2]. Figures include deductions for property taxes and other state and local taxes.
[3]. Office of Management and Budget, Budget of the United States Government, Fiscal Year 2011: Analytical Perspectives, p. 240.
[4]. Congressional Research Service, Tax Expenditures: Compendium of Background Material on Individual Provisions (December 2008), p. 917–918.
[5]. The “Alternative Minimum Tax” eliminates the tax preference for state and local taxes and thus reduces the benefit of the deduction for the mainly high-income families who currently pay the AMT.