Limit or Eliminate the Deduction for State and Local Taxes

In determining their taxable income, taxpayers may choose the standard deduction when they file their tax returns or they may itemize and deduct certain expenses (including state and local taxes on income, real estate, and personal property) from their adjusted gross income (AGI). Under the American Jobs Creation Act of 2004, taxpayers who itemized were allowed to deduct state and local sales taxes, which previously had not been deductible, instead of state and local income taxes. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312, referred to in this report as the 2010 tax act) extended that provision through 2011. Beginning in 2013, with the expiration of the 2010 tax act, the total value of certain itemized deductions--including the deduction for state and local taxes--will be reduced if the taxpayer's AGI is above a specified threshold.

This option would change the deductibility of state and local tax payments, either by eliminating the deduction or by restricting it to an amount equal to or less than 2 percent of AGI. Eliminating the deduction would increase federal revenues by $345 billion from 2012 through 2016 and by $862 billion from 2012 through 2021. Capping the deduction at 2 percent of AGI would increase revenues by $253 billion over five years and by $629 billion over 10 years.

Those revenue estimates reflect the assumption that the alternative minimum tax (AMT) would continue to operate as it does under current law. (Federal tax liability is computed differently under the AMT than it is under the regular income tax because the former allows a more limited set of exemptions, deductions, and tax credits; taxpayers pay the higher of their regular tax or the AMT.) Because the deduction for state and local taxes is the largest item that must be added back into income under the AMT, assumptions regarding the AMT have a substantial effect on the revenue estimates for this option. Under current law, the number of taxpayers who pay the AMT will grow each year because the exemption amounts and brackets for the AMT are not indexed for inflation. As the scope of the AMT expands, fewer people will benefit from the deduction for state and local taxes. However, policymakers have routinely changed the requirements to limit the number of taxpayers affected by the AMT. If legislation that limited AMT liability was already in place, more taxpayers would benefit from the deduction for state and local taxes--and eliminating that deduction would result in a larger revenue gain than would be the case under current law.

The deduction for state and local taxes is effectively a federal subsidy to state and local governments. As such, it indirectly finances spending by those governments at the expense of other uses of federal revenues. Either variation of this option would substantially reduce the incentive that the current subsidy provides for state and local government spending, although some research indicates that total state and local spending is not sensitive to that incentive.

An argument in favor of curtailing the deduction is that the federal government should not subsidize state and local governments through the tax deduction because state and local taxes are largely paid in return for services provided to the public. If that is the case, such taxes are analogous to spending on other types of consumption, which are nondeductible. Another argument is that the deduction largely benefits wealthier localities, where many taxpayers itemize, are in the upper income tax brackets, and enjoy more abundant state and local government services. Because the value of an additional dollar of itemized deductions increases with the marginal tax rate (the rate on the last dollar of income), the deductions are worth more to taxpayers in higher income tax brackets than they are to those in lower income brackets. Additionally, the deductibility of taxes could deter states and localities from financing services with nondeductible fees, which could be more efficient.

An argument against eliminating or restricting the current deduction involves the equity of the tax system. A person who must pay relatively high state and local taxes has less money with which to pay federal taxes than does someone with the same total income and smaller state and local tax bills. The validity of that argument, however, depends at least in part on whether people who pay higher state and local taxes also benefit more from goods and services provided by states and localities.