April 14, 2015

Get Rid of State and Local Tax Deductions

Veronique de Rugy

Senior Research Fellow
Summary

Genuine income tax reform would lower tax rates, reduce double taxation of income that is saved and invested, and cut out loopholes that tilt the playing field in favor of politically connected interest groups. In this vein, we should get rid of deductions that let taxpayers write off state and local income taxes. I’m all for people keeping more of their income, but this exemption actually leads to bad policy by state and local government.

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The New York Times Room for Debate posted this question: What are the most useless, unfair or counterproductive personal tax breaks?

Veronique de Rugy provided the following response:
Genuine income tax reform would lower tax rates, reduce double taxation of income that is saved and invested, and cut out loopholes that tilt the playing field in favor of politically connected interest groups.

In this vein, we should get rid of deductions that let taxpayers write off state and local income taxes. I’m all for people keeping more of their income, but this exemption actually leads to bad policy by state and local government.

This loophole lets politicians raise taxes without upsetting voters as much as they should be, because this additional burden can be deducted from their federal tax bill. But people in responsible low-tax states shouldn't be paying higher taxes to subsidize profligacy in high-tax states like California and Illinois to make up for this federal largesse.

State and local governments are also encouraged to spend more wastefully by the federal income tax exemption on interest received for lending money to those governments through municipal bonds. That deduction should go, too. It encourages state officials to incur more debt and artificially steers private capital toward state and local government at the expense of private investments.

But every penny of revenue raised by reforming state and local tax deductions should be used to lower marginal tax rates, not to finance bigger government.

Of course, while all tax exemptions help crowd out other possible tax reforms, they aren’t equally bad. Tax provisions that merely allow people to avoid being double-taxed — such as those for retirement saving or the tax treatment of capital gains and dividends — mitigate biases embedded in the tax code. They don’t compare to the state and local government deductions — or even health care exclusions — which are mere handouts to special interests. Unfortunately, outfits like the Joint Committee on Taxation or the Congressional Budget office fail to make the distinction, compromising the potential for productive tax reform.