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Reagan's Tax Revolution: Ending the Free Ride for State and Local Taxes

June 14, 1985 9 min read Download Report

Bruce Bartlett

Senior Associate Fellow

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June 14, 1985

REAGAN'S TAX REVOLUTION: ENDING THE FREE RIDE FOR STATE & LOCAL TAXES

INTRODUCTION

Ronald Reagan's proposal to eliminate the deductibility of state and local nonbusiness taxes from the federal tax base is among the most controversial provisions in his tax reform plan This deduction has existed since the creation of the federal income tax in 1913. Yet there is a strong case for eliminating it as an integral part of an overall tax reform. Today's deduc- tion for state and local taxes favors the rich over the poor and affluent states over low-income states, and it discourages more efficient methods of financing and delivering state and local services. As such, its elimination is one of the most important provisions in the Reagan tax plan and is central to the attempt to make the U.S. tax system fairer and simpler.

This is the first of a series on the President's tax reform plan. Future studies will examine the plan's impact on families and the poor, inter- national finance and trade, energy policy and industries, financial institutions, and savings investment and risk-taking. For a brief overview of the plan, see Bruce Bartlett, "Two Cheers for the Reagan Tax Revolution," Heritage Foundation Executive Mem No. 81, May 29, 1985. For an analysis of the President's earlier tax-plan, Treasury I, see Grover Norquist, "One Cheer for the Treasury Tax Plan," Heritage Foundation Backgrounder No. 397, December 17, 1984.

THE INEQUALITIES OF THE DEDUCTION

Under current law a taxpayer who itemizes is allowed to deduct from his adjusted gross income all income, sales, and property taxes paid to state and local governments. on the other hand, those who do not itemize--approximately two-thirds of all taxpayers--receive no advantage from this deduction.

A Benefit for the Rich

The benefits of this tax break accrue largely to more wealthy taxpayers, partly because they tend to pay more state and local taxes and partly because each dollar of the deduction is worth more for those in the higher marginal tax brackets. As Table 1 illustrates, those with economic incomes above $50,000 account for two-thirds of the deduction for state and local taxes.

Source: Treasury Department.

The deduction for state and local taxes is among the fastest growing tax breaks. In 1970, $32 billion of these taxes were deducted at the federal level. By 1983 this figure had ballooned to over $100 billion.z The Congressional Budget Office estimates that eliminating deductibility would raise federal revenues by $176.2 billion between 1986 and 1990, in the absence of any other tax change, assuming there is no impact on economic growth.

Treasury Department estimates that eliminating deductibility would raise revenues by $148.9 billion4 between 1986 and 1990 if it were part of an overall tax reform proposal that also lowers marginal tax rates. The difference between the two figures is largely due to the fact that under current law the top tax rate rises to 50 percent while under the President's proposal it would be no higher than 35 percent.

A Break for Rich States

The value of deductibility for taxpayers varies widely between states. It predictably is greatest in those states where taxes are the highest. The-Advisory Commission on Intergovern-@ mental Relations (ACIR) estimates the tax savings from deducti- bility at $263 per capita for a New York resident, but only $33 per capita for a Tennessee resident. Table II lists the figures for all states in descending order of the value of the deduction. The biggest benefits go mainly to the richer states in the north- east and the west.

Source: Advisory Commission on Intergovernmental Relations.

Because the benefits of deductibility vary so widely, the state and local tax deduction in effect forces lower-taxed states to subsidize higher-taxed states. And because the states with heavier state and local taxes tend to be wealthier in terms of per capita income, deductibility constitutes a subsidy from the poor to the rich. The 15 states with above average tax savings from deductibility, for example, have average per capita incomes over 17 percent higher than those states with less than average tax savings from deductibility.

For Itemizers only The deductibility of state and local taxes is also a subsidy from the poor to the rich within each state. This is because deductibility benefits only those who itemize--generally the more wealthy taxpayers. Those who use the standard deduction gain absolutely nothing from the deductibility of state and local taxes. Only 37 percent of all U.S. taxpayers itemize deductions in their tax returns. The share of itemizers in each state, however, varies from Utah's high of 50 percent to West Virginia's low of 19 percent.4 University of Michigan economist Edward Gramlich explains in a recent study that user fees and charges, which are generally more efficient methods of raising revenue, are not deductible while less efficient sales and income taxes are. Notes Gramlich: "the deduction ... merely represents an unwarranted tax break for the high-income taxpayers who do itemize.116.

Homeowners vs. Renters

The deductibility of property taxes biases the tax code against renters and in favor of homeowners. A 1977 Treasury study notes that rents contain a share of property taxes paid by the landlord. over time, rents will rise dollar-for-dollar with an increase in the property tax. Yet only homeowners and land- lords will be relieved of part of this burden by being able to deduct such taxes from their taxable income. Renters will not.@ And to the extent that homeowners are generally wealthier than renters, this again means that deductibility constitutes a subsidy from the poor to the rich.

This is also true of the deductibility of sales taxes, which must be paid regardless of one's income. Thus the inherent regressivity of sales tax is increased by allowing such taxes to be deducted from taxable income. A dollar's worth of sales tax will cost a dollar to taxpayers who do not itemize or whose income is so low that they pay no taxes. But it will cost some- one in the top federal tax bracket only 50 cents under current law. The result: the rich enjoy government services at less cost than the poor. This deductibility, in effect, is income redistribution in reverse.

THE IMPACT OF STATE AND LOCAL SPENDING

Deductibility of state and local taxes is estimated to increase overall state and local government spending by as much as 20.5 percent, according to the Congressional Research Service-4 The ACIR puts it at only 7 percent--which would still be about $30 billion in 1983.V Most other estimates put the figure at 13 to 14 percent.1y This means that, without federal deductibility for state and local taxes, state and local spending would be about 14 percent less than it now is and would fall by this amount in the absence of deductibility. It is unlikely, of course, that it would fall immediately, but the relative pressure to raise spending would.

If the nation as a whole benefited from having state and local spending subsidized and encouraged by the federal tax code, there might be some case for keeping the deductibility. Yet, writes Harvard Professor Helen Ladd, to accept this argument, "one would have to believe that such spillovers are positive in jurisdictions with large proportions of itemizing taxpayers and zero elsewhere. In fact, the reverse is more likely to be true.

HOW THE DEDUCTION BOOSTS STATE AND LOCAL TAXES

Deductibility makes state and local taxes politically easier to impose. As such, it encourages state and local governments to establish progressive income taxes in contrast to flat-rate income taxes. The advantages, notes economist Edward Moscovitch, are:

the ability to shift a much greater share of the state income tax burden onto the federal government, and the abili+-y to increase state income tax revenues ... without incre-ising taxes on low- and moderate-income families.... By shifting state taxes onto those taxpayers in the highest federal tax brackets, the adoption of graduated rates increases the total amount of federal tax savings, and thereby reduces the total burden of a state income tax. In effect, adoption of graduated rates offers an opportunity for the state to participate in a form of state-initiated revenue sharing.

Moscovitch estimates that in 1973 Massachusetts could have saved over $100 million simply by shifting from a flat-rate income tax schedule to a progressive rate schedule.

Marginal tax rates vary a great deal between states and localities. Several states have no income taxes whatsoever, while rates rise to over 18 percent elsewhere. Deductibility of such taxes from federal taxable income, however, cushions the impact of such tax rates, making it easier for states to impose taxes on those who are politically active but itemize their tax returns. In short, deductibility reduces the progessivity of tax rates--but again, only for those who itemize.14 Table III illustrates the impact of deductibility and how the President's proposal will affect taxpayers in the top tax bracket among the different states.

Table III Highest.Marginal Tax Rate by State Under Current Law and Reagan Proposal

State Current Law Reagan Proposal (Top rate of 50% (Top rate of 35% plus deductibility) and no deductibility)

Source: Calculated from data of the Advisory Commission on Intergovernmental Relations.

Naturally, those states with tax rates substantially above the national average worry that loss of federal tax deductibility will sharpen the differences in tax rates among the states. They know full well from past experience that taxpayers "vote with their feet" and move to states with less tax bite. It thus would become more difficult for states to finance programs of doubtful benefit to their taxpayers by "hiding" the full cost within the federal tax system.

It should be no surprise that states protesting the proposed tax loss of tax deductibility most loudly are mainly those, such as New York, that are high taxers and big spenders. Many of these states have offset the recent decrease in federal subsidies with increased state spending, cushioned by the deductibility of state taxes, which has meant that the increased taxes have been borne partially by Uncle Sam. Now they fear that they will have to cut back on the spending that is currently subsidized by the federal tax code. And well they may. Loss of deductibility of state and local taxes could trigger the most powerful tax revolt since 1978, the days of Proposition 13 in California. It threatens the political livelihood of spendthrift lawmakers across the nation.

The Privatization Option

Despite the loud complaints of many state and local politi- cians, making it more difficult for them to raise taxes does not mean that government cannot carry out its obligations. The main activity of state and local governments, in contrast to the federal government, is to deliver goods and services--police and fire protection, trash collection, education, parks, and similar services. In 1983, for example, 95.8 percent of all state and local spending went to providing goods and services, according to the Department of Commerce, compared with only 32.9 percent of federal spending. Numerous studies show, however, that it is far less expensive to provide most of these goods and services through the private sector.14 municipal and state governments therefore could cut costs dramatically by contracting with private firms to provide a broad array of services. Even now, condominium residents and other citizens' groups shop around for such services as garbage pickup and security and end up paying less for them than if they paid local taxes for the services. But since such private fees are not deductible from federal taxable income, while payments of local taxes are, after-tax cost of private services is often higher to the taxpayer than such services funded by taxes. With the loss of deductibility, therefore, privatization and contract- ing out of state and local government services are no longer at a disadvantage.

CONCLUSION

Without the elimination of the deduction for state and local taxes, tax reform is essentially impossible. Without the $149 billion revenue gain from this provision in the Reagan plan, there simply will not be enough revenue to offset more than a modest reduction in tax rates--perhaps too little to make the exercise worthwhile. Since the state and local deduction mainly benefits Americans with upper incomes, its elimination restores balance among the various income sectors. This balance disappears if state and local deductibility is kept in the tax code. Ironi- cally, therefore, those who battle against eliminating deducti- bility are effectively against any tax reform--and they wish to retain a deduction that favors the rich.

To be sure, means may be devised to make the end of the deduction less painful for state and local governments. It might be phased out over a few years to ease the fiscal impact. Or an additional tax bracket could be added between 25 and 35 percent; this would ease the loss of deductibility for the vast majority of itemizers."'.

Whatever is done to buffer the transition, Congress must remember that deductibility benefits only a relatively small number of taxpayers in a small number of states. Congress must also recognize that the U.S. pays a heavy price in terms of economic efficiency for a tax system riddled with deductions like that for state and local taxes.16 There is no question that the nation as a whole would be better off without it even if federal .tax rates are not reduced."" When coupled with rate reductions, the nation gains a cleaner, fairer, more efficient tax system.

The President's Tax Proposals to the Congress for Fairness, Growth and Simplicity (Washington, D.C.: Government Printing Office, 1985 62-69; Milton Coleman, "Ending State, Local Deduction Controversial," The Washington Post, May 29, 1985, p. A15;

Jacob Javits, "The Treasury's Trojan Horse," The New York Times, May 14, 1985; Editorial, "Guess Who Pays for Tax 'Reform,"' The New York Times, May 26, 1985.

4 The Internal Revenue Service, Statistics of Income Bulletin 4 (Spring 1985), p. 78.

4. Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options (Washington, D.C.: Government Printing Office, 1985), p. 291.

4 The Internal Revenue Service, Statistics of Income Bulletin 4 (Spring 1985), p. 78.

4. Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options (Washington, D.C.: Government Printing Office, 1985), p. 291.

Strengthening the Federal Revenue System: Implications for State and Local Taxing and Borrowing (Washington, D.C.: Advisory Commission on Intergovernmental Relations, 1984), pp. 44-45.

Edward M. Gramlich, "Reforming U.S. Federal Fiscal Arrangements," in John M. Quigley and Daniel L. Rubinfeld, eds., American Domestic Priorities: An Economic Apgraisal (Berkeley, California: University of California Press, 1985), p. 50.

Blueprints for Basic Tax Reform (Washington, D.C.: Department of the Treasury, 1977), p. 87.

See also Harvey E. Brazer, "The Deductibility of State and Local Taxes Under the Individual Income Tax," in Tax Revision Com- pendium, Committee Print, House Ways and Means Committee, 86th Congress, 1st Session (Washington, D.C.: Government Printing Office, 1959), vol. 1, p. 414.

Nonna A. Noto and Dennis Zimmerman, Limiting State and Local Tax Deducti- bility in Exchange for Increased General Revenue Sharing: An Analysis-of the Economic Effects, Committee Print, Senate Committee on Governmental Affairs, 98th Congress, Ist Session (Washington, D.C.: Government Printing Of f ice, 1983), p. 11.

Strengthening the Federal Revenue System, p. 48. en F. Ladd, "Federal Aid to State and Local Governments," in Gregory B. Mills and John L. Palmer, eds., Federal Budget Policy in the 1980s (Washington, D.C.: Urban Institute, 1984); Roger H. Gordon and Joel Slemrod, "A General Equilibrium Simulation Study of Subsidies to Munici- pal Expenditures," Journal of Finance 38, May 1983, pp. 585-594. Ladd, op. cit., p. 196.14 E. S. Savas, Privatizing the Public Sector (Chatham, New Jersey: Chatham House Publishers, 1982); James T. Bennett and Manuel H. Johnson, Better Government at Half the Price (Ottawa, Illinois: Caroline House Publishers, 1981); Robert Poole, Jr., Lutting Back City Hall (New York: Universe Books, 1980).Bruce Bartlett Senior Fellow

15. One option that definitely should not be considered is the elimination of deductibility for only selected state and local taxes. This would just cause state and local governments to alter their tax systems toward those taxes that retain deductibility. See Ladd, op. cit., p. 196.

1b Jacquelene M. Browning, "Estimating the Welfare Cost of Tax Preferences," Public Finance Quarterly 7, April 1979, pp. 199-219.

Gordon and Slemrod find that even without reducing rates Liminating deductibility "raises the utility of all income groups, and of home owners as well as of renters." Gordon and Slemrod, op. cit., p. 585.