One of the many reasons we need tax reform is that our current system encourages bad economic policy at the state level and subsidizes wealthy individuals.
You heard that right. The tax deductions for state and local income taxes and for municipal bond interest function as subsidies for states that have high taxes and lots of debt. They also give huge benefits to the wealthy.
You might say that’s grossly unfair—and you’d be quite right.
A forthcoming analysis from The Heritage Foundation will show that these state and local tax breaks amount to nearly $1.7 billion in lost federal revenues over 10 years.
By eliminating these deductions, policymakers could reduce marginal tax rates by as much as 16 percent without losing any revenue. This would give tax relief to the 70 percent of federal taxpayers who do not itemize, and therefore receive no benefit from the state and local tax deduction.
That’s exactly the type of pro-growth tax reform that policymakers have been talking about—getting rid of special-interest tax breaks that hurt, rather than help the economy, and replacing them with lower tax rates for everyone.
So why are some policymakers trying to preserve the state and local deductions, or convert them into another equally irrational and preferential tax break? Probably because that’s what happens when special interests and powerful constituents come knocking on politicians’ doors.
To understand just how nonsensical and detrimental these tax breaks are, consider the following.
The tax deduction encourages states to tax and spend more than they otherwise would.
Because federal taxpayers pick up a big portion of the tab, state and local governments spend more than they should, doing things like turning personal trash collection into a public, taxpayer-provided service.
And when they face budget shortfalls, the deduction makes tax increases preferable over spending cuts because federal taxpayers end up picking up as much as 40 percent of the tab.
Wealthy taxpayers receive the bulk of the deduction.
The state and local tax deduction is worth $6,300 for taxpayers with incomes over $200,000, but only $134 to those with incomes of $45,000. And it’s worth nothing to the 70 percent of taxpayers who don’t itemize.
The state and local tax deduction benefits high-tax states.
Just seven high-tax states receive more than 50 percent of the value of the deduction: California, New York, New Jersey, Illinois, Massachusetts, Maryland, and Connecticut. No wonder lawmakers in those states are pushing to spare or revamp the deduction.
The municipal bond deduction distorts infrastructure spending.
By making it easier for states to accumulate debt, a direct consequence of this deduction has been for state and local governments to turn what should be private infrastructure projects into public, taxpayer-supported ones.
Since 2000, 36 professional sports stadiums have received tax-exempt municipal bond financing, amounting to a $3.2 billion subsidy to the issuers and $3.7 billion in lost federal revenue.
State and local tax deductions make federal revenues beholden to state and local government decisions.
If state and local governments raise taxes or issue more debt, federal tax revenues automatically decline because taxpayers can deduct more of their incomes on federal taxes.
This makes it harder for the federal government to maintain a system that provides adequate revenues without raising taxes or issuing new debt in response to changes in state and local government policies.
With such adverse and damaging effects, it’s hard to argue for keeping the state and local tax and municipal bond interest deductions. That’s especially true when eliminating them would allow for an average rate reduction of 7 percent, with middle-income rates declining by as much as 16 percent.
Policymakers should stick to their stated objectives of lowering rates and eliminating special-interest and unproductive tax breaks. Eliminating the state and local tax and municipal bond interest deductions is one of the best ways to achieve those goals.
Rachel Greszler is a senior policy analyst in economics and entitlements at The Heritage Foundation's Center for Data Analysis.
Editor's Note: This piece was originally published by The Daily Signal.