The 2017 tax law capped at $10,000 the amount of state and local tax payments a household can deduct from its federal income taxes. Previously, people could deduct the entire amount they paid in state and local property taxes, and either the state individual income tax or state sales tax.
According to a Treasury Department estimate released Tuesday, this cap will stop 10.9 million tax filers from writing off these payments from their federal income taxes, with the largest bite felt in high-tax states like New York, New Jersey and California. Though politicians from these states are howling — New York Governor Andrew Cuomo recently met with President Donald Trump to discuss his concerns — limiting this deduction was the right thing to do. Congress should go all the way and repeal what remains of it.
Importantly, just because 11 million people may lose this popular tax break — which has been in the federal code since the income tax was created a century ago — does not mean that all of them will be paying a larger share of their income in federal taxes. An analysis by the Tax Policy Center in December 2017 found that 80 percent of households would receive a tax cut in 2018, while only 5 percent will face a tax increase. (As temporary provisions of the 2017 law expire, more households will face a tax increase in future years.)
An initially appealing argument in favor of this deduction is that it reduces an individual’s marginal income tax. Imagine you are in the 35 percent income tax bracket and you earn an additional $100. Say you owe $10 in state taxes on that extra income. If you can deduct the $10 state tax payment, you now pay 35 percent on the remaining $90. Overall, you get to keep $58.50 after taxes. But if you can’t deduct the $10, you can only keep $55 after taxes.
So far, it seems that the deduction lowers marginal tax rates, improving incentives to work, save and invest. But that’s only part of the story. By shrinking the federal income tax base relative to what it would be without the deduction, raising any given amount of revenue requires higher tax rates. This likely offsets the deduction’s marginal rate reduction.
The state and local deduction also encourages taxpayers to itemize their deductions rather than take the standard deduction. This leads people to use other deductions more as well, amplifying the harm done from much less defensible tax breaks, like the one for mortgage interest payments. For the reasons I mentioned above, we should want a broader base and lower rates, not a smaller base and higher rates.
In addition, the state and local deduction is a subsidy to states with large numbers of high-income individuals. Because they face higher marginal income tax rates, deductions are relatively more valuable to this group of taxpayers. (If you are in the 12 percent bracket, a deduction saves you 12 cents on your next dollar of income, compared with 35 cents if you are in the 35 percent bracket.)
Also, rich states are often high-tax states. And because states with high-income residents also have larger populations (New York, New Jersey, California, Illinois), the state and local deduction benefits places that are doing much better than many others, and distorts the tax-and-spending decisions made by these states’ governments.
Supporters of this write-off argue that it prevents double taxation — to stop the same dollar of income from being taxed by both the federal and state government, taxes paid to the state should be excluded from income subject to federal tax.
But that argument doesn’t really hold. State and local taxes are essential payments for goods and services, like schools, roads, police and fire departments, and public parks. Higher-tax states choose to provide more, or a better quality, of these services. Lower-tax states make a different choice.