Order Code RL32781
Federal Deductibility of State and Local Taxes
Updated July 31, 2008
Steven Maguire
Specialist in Public Finance
Government and Finance Division

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Federal Deductibility of State and Local Taxes
Summary
Under current law, taxpayers who itemize can deduct state and local real estate
taxes, personal property taxes, and income taxes from federal income when
calculating taxable income. In addition, a temporary deduction for sales taxes in lieu
of income taxes expired December 31, 2007. The federal deduction for state and
local taxes results in the federal government paying part of these taxes through lower
federal tax collections. Theory would suggest that taxpayers are willing to accept
higher state and local tax rates and greater state and local public spending because
of lower federal income taxes arising from the deduction. In addition, there is some
evidence that state and local governments rely more on these deductible taxes than
on nondeductible taxes and fees for services.
Repealing the deductibility of state and local taxes would affect state and local
government fiscal decisions, albeit indirectly. Generally, state and local public
spending would decline, although the magnitude of the decline is uncertain. And,
repealing the deduction for state and local taxes would shift the federal tax burden
away from low-tax states to high-tax states. Maintaining the current deductibility
would continue the indirect federal subsidy for state/local spending.
Expanding deductibility, such as extending the sales tax deduction option or
allowing non-itemizers to deduct taxes paid, would likely increase the subsidy for
state and local spending. The sales tax deduction option would primarily benefit
taxpayers in states without an income tax that are already itemizing. The effect of
allowing non-itemizers to deduct taxes paid would depend on the type of deductible
tax. For example, property taxes are only paid (directly) by property owners whereas
all consumers pay sales taxes in states that levy a sales tax.
On December 20, 2006, the Tax Relief and Health Care Act of 2006 (P.L. 109-
432) was enacted, extending the sales tax deduction option for the 2006 and 2007 tax
years. In the 110th Congress, legislation has been introduced that would (1) extend
the sales tax deduction option through 2008 or (2) make the sales tax deduction
permanent. H.R. 6049, which was approved by the Ways and Means Committee on
May 15, 2008, would extend the sales tax deduction one year, through 2008. Making
the sales tax deduction option permanent would cost $37.1 billion over the FY2009
to FY2018 budget window ($3.0 billion in FY2009).
Other legislation expanded the deduction for property taxes paid. On July 30,
2008, the President signed H.R. 3221 (P.L. 110-289), which includes a provision that
allows non-itemizers to deduct up to $500 ($1,000 for joint filers) of property taxes
paid for the 2008 tax year.
This report will be updated as legislative events warrant.

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Contents
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Brief History . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Deductible State and Local Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Deduction for Property Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Deduction for Income Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Deduction for Sales and Use Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Explanation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Policy Alternatives and Current Legislation . . . . . . . . . . . . . . . . . . . . . . . . . 9
Federal Tax Base Broadening: Eliminate Deductibility of
State and Local Taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Making the Sales Tax Deduction Permanent . . . . . . . . . . . . . . . . . . . . 11
Other Policy Considerations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
President’s Advisory Panel on Federal Tax Reform . . . . . . . . . . . . . . 12
List of Tables
Table 1. Number and Percentage of State and Local Taxes Paid Itemizers,
1986 and 1998 to 2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Table 2. Estimated Federal Tax Expenditure on the
Real Estate Property Tax Deduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Table 3. Estimated Federal Tax Expenditure on the State and
Local Income, Sales, and Personal Property Tax Deductions . . . . . . . . . . . . 8
Table 4. Type of Tax Revenue, Non-Income Tax States and
Income Tax States, FY2006 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

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Federal Deductibility
of State and Local Taxes
Introduction
The interplay between the federal and state and local tax systems through the
federal deductibility of state and local taxes is the focus of this report. Generally,
individual taxpayers who itemize deductions are allowed to deduct real and personal
property taxes, and general sales taxes or state and local income taxes from federal
taxable income. Taxpayers must choose between sales taxes or income taxes; they
cannot deduct both. In 2004, Congress modified the deductibility of state and local
taxes — adding the sales tax deduction option for 2004 and 2005 — and the 109th
Congress extended the sales tax deduction option for 2006 and 2007.
In the 110th Congress, 11 bills have been introduced that would make the sales
tax deduction permanent: H.R. 60, H.R. 411, H.R. 2734, H.R.3592, H.R. 3906, H.R.
4086, H.R. 5242, H.R. 5744, S. 143, S. 180, and S. 2233. Four bills, H.R. 3680,
H.R. 3970, H.R. 6049 (which passed in the House on May 21, 2008), and S. 3335
would extend the sales tax deduction option for one year. S. 2886 would extend the
sales tax deduction option for two years, through 2009.
The recent housing crisis has generated interest in Congress to modify the
deduction for real property taxes. H.R. 3221, (P.L. 110-289), the Housing and
Economic Recovery Act of 2008, signed by the President on July 30, 2008, includes
a provision that allows non-itemizers to deduct up to $500 ($1,000 for joint filers)
of property taxes paid. The special deduction is available for the 2008 tax year under
the legislation.
The tax savings under the property tax deduction, which will be realized in
spring 2009 when taxpayers file 2008 returns, will likely benefit taxpayers that do not
have other potentially deductible expenses that are high enough to merit itemizing.
Taxpayers with no mortgage (or low mortgage debt) in states with relatively low state
and local tax burdens would likely benefit the most from this new tax provision.
The President’s Advisory Panel on Federal Tax Reform (the tax reform panel)
recommended repealing the deduction for all state and local taxes as part of a more
comprehensive base broadening plan. The President’s FY2009 budget proposal does
not include an extension of the sales tax deduction option. This report addresses the
potential impact of changing the status of federal deductibility on state and local
government tax systems, individual taxpayers, and the federal budget.

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Brief History
The deduction from federal income for state and local taxes paid dates from the
inception of the current income tax under the Revenue Act of 1913.1 A provision in
that act allowed the deduction for “all national, State, county, school and municipal
taxes paid within the year, not including those assessed against local benefits.” State
sales taxes, however, were not introduced until 1932 (Mississippi was the first) and
a deduction for those taxes for individuals was not explicitly stated in the tax code
until passage of the Revenue Act of 1942 (P.L. 77-753). The deductibility provision
was frequently modified over the years, including the introduction of the standard
deduction in lieu of itemizing deductions in 1944, but significant revision did not
occur until 1964 with enactment of the Revenue Act of 1964 (P.L. 88-272).
Before the 1964 act, a deduction was allowed for all state and local taxes paid
or incurred within the taxable year except those taxes explicitly excluded. After the
1964 Act, only taxes explicitly mentioned were deductible. Included in the list of
deductible taxes were state and local taxes on: real and personal property, income,
general sales, and the sale of gasoline, diesel fuel, and other motor fuels. A new
subsection in the 1964 act spelled out the test for deductibility of general sales taxes.
First, the tax must be a sales tax (a tax on retail sales) and second, it must be general,
that is, imposed at one rate on the sales of a wide range of classes of items. “Items”
could refer either to commodities or services.
The deductibility provision remained largely unchanged until the sales tax
deduction was repealed by the Tax Reform Act of 1986 (TRA 1986, P.L. 99-514).
One of the primary goals of TRA 1986 was to broaden the base of the federal income
tax. Eliminating the deduction for all state and local taxes paid was one of the policy
options considered to broaden the tax base. The final version of TRA 1986 repealed
the deduction for general sales taxes but preserved the deduction for ad valorem
property taxes and income taxes. The Joint Committee on Taxation (JCT) summary
of TRA 1986 suggested that Congress chose to repeal the sales tax deduction and not
income or property taxes, because:
! only general sales taxes were deductible and not selective sales taxes
(e.g., tobacco and alcohol taxes) which created economic
inefficiencies arising from individuals changing consumption
patterns in response to differential taxation;
! the deduction was not allowed for taxes paid at the wholesale level
(and passed forward to the consumer), thus creating additional
inequities and inefficiencies;
! the sales tax deduction was administratively burdensome for
taxpayers who chose to collect receipts to justify sales tax deduction
claims; and
1 The 16th Amendment allowed for the taxation of income without regard to apportionment
among the states. With the new constitutional authority, Congress passed The Revenue Act
of 1913, initiating the current federal income tax.

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! the alternative sales tax deduction tables generated by the Internal
Revenue Service (IRS) did not accurately reflect individual
consumption patterns, thereby diminishing the equitability of the tax
policy.2
The American Jobs Creation Act of 2004, (AJCA 2004, P.L. 108-357),
reinstated deductible sales tax in lieu of income taxes.3 The in lieu of treatment in
AJCA 2004 is in contrast to the “in addition to” treatment in pre-TRA 1986 tax law.
The concerns noted above would still hold. A secondary concern — presented during
the debate before repeal in 1986 — that states would alter their tax structures in
response to the elimination of sales tax deductibility, would not arise. The AJCA
2004 sales tax deductibility provision expires after the 2005 tax year, but was
extended through 2007 by the Tax Relief and Health Care Act of 2006 (P.L. 109-
432).
The remainder of this report will describe and analyze the deduction for the
following state and local taxes: (1) real estate property taxes; (2) personal property
taxes; (3) income taxes; and (4) sales and use taxes. As Congress considers possible
extension of the sales tax deductibility provision and proposals for fundamental tax
reform, a better understanding of the existing deductible state and local taxes is
important.
Deductible State and Local Taxes
Generally, taxpayers may deduct state and local taxes from income. Individual
taxpayers, however, must itemize deductions (rather than use the standard deduction)
on their income tax return to claim the deduction for taxes paid. Business taxpayers,
in contrast, may deduct state and local taxes as a cost of doing business. The federal
tax savings from the deduction is equal to the taxpayer’s marginal tax rate multiplied
by the size of the deduction. Because the federal income tax rate regime is
progressive,4 a deduction for itemizers, in contrast to a tax credit for all taxpayers,
favors taxpayers in higher income tax brackets. Table 1 reports the number and
percentage of returns with itemized deductions for the four state and local taxes
described and analyzed in this report.
The 1986 tax year is included in Table 1 to exhibit the utilization of the
deduction for sales taxes paid, which was repealed by TRA 1986. In 1986, the sales
tax deduction was the most common itemized deduction for taxes paid. More
taxpayers would claim a sales tax deduction because all but five states imposed a
sales tax and, in contrast to property taxes, paying the tax is not conditioned on
2 For more on the 1986 Act, see U.S. Congress, Joint Committee on Taxation, General
Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th Congress; P.L. 99-514), 100th
Cong., 1st sess., JCS-10-87 (Washington: GPO, 1987), pp. 47-48.
3 IRS Publication 600, Optional Sales Tax Tables, provides a explanation of the new sales
tax deduction.
4 A progressive tax is one in which the rate of tax increases with income.

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owning property, real or personal. The current sales tax deduction will not be as
common because it is in lieu of income taxes. In 2006, 11.2 million taxpayers
claimed a deduction for sales taxes paid, and the number who claimed a deduction
for income taxes paid declined slightly from 35.9 million in 2003 to 35.7 million in
2006.
The gradual growth in the percentage of itemizers through 2002 (exhibited in
Table 1) may reflect income growth that has outpaced inflation. Income growth that
exceeds the inflation-adjusted expansion of income tax brackets (bracket creep)
implies a higher marginal tax bracket, which ultimately increases the tax saving from
itemizing. The decline in 2003 may reflect the impact of lower marginal tax rates.
The total number and percentage of itemizers increased from 43.9 million in 2003 to
46.3 million in 2004, likely reflecting introduction of the sales tax deduction option.
Table 1. Number and Percentage of State and
Local Taxes Paid Itemizers, 1986 and 1998 to 2006
(return numbers in millions)
1986
1998
1999
2000
2001
2002
2003
2004
2005
2006
Number of returns
All Returns:
103.0
124.8
127.1
129.4
130.3
130.1
130.4
132.2
134.4
138.4
Itemized Deductions
40.7
38.2
40.2
42.5
44.6
45.6
43.9
46.3
47.8
49.1
— Income Taxes
33.2
31.9
33.6
35.4
37.0
37.6
35.9
33.5
34.6
35.7
— Sales Taxes
39.0
n/a
n/a
n/a
n/a
n/a
n/a
11.2
11.4
11.2
— Real Estate Taxes
32.9
33.6
35.4
37.1
38.7
39.7
38.3
40.5
41.3
42.6
— Personal Property
11.5
18.2
19.0
19.6
20.0
20.6
20.0
21.1
21.3
21.5
Taxes
— Other Taxes
9.1
3.4
3.4
3.3
3.7
3.4
3.2
3.0
2.8
3.1
Percentage of all returns
All Returns
100%
100%
100%
100%
100%
100%
100%
100%
100%
100%
Itemized Deductions
39.5
30.6
31.7
32.9
34.2
35.1
33.7
35.0
35.6
35.5
— Income Taxes
32.2
25.6
26.4
27.4
28.4
28.9
27.5
25.3
25.7
25.8
— Sales Taxes
37.8
n/a
n/a
n/a
n/a
n/a
n/a
8.5
8.5
8.1
— Real Estate Taxes
32.0
27.0
27.9
28.7
29.7
30.5
29.4
30.6
30.7
30.8
— Personal Property
11.1
14.6
15.0
15.2
15.3
15.8
15.3
16.0
15.8
15.5
Taxes
— Other Taxes
8.8
2.7
2.6
2.6
2.8
2.6
2.5
2.3
2.1
2.2
Source: U.S. Department of Treasury, Internal Revenue Service, Statistics of Income Division,
Individual Income Tax Returns, various years, Publication 1304.
Economists have theorized that if a particular state and local tax is favored by
deductibility in the federal tax code, then state and local governments may rely more
upon that tax source.5 In effect, local governments and taxpayers recognize that
5 Lawrence B. Lindsey, “Federal Deductibility of State and Local Taxes: A Test of Public
Choice by Representative Government,” in Fiscal Federalism: Quantitative Studies, edited
(continued...)

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residents are paying only part of the tax, and that the federal government, through
federal deductibility, is paying the remainder. For example, economists Douglas
Holtz-Eakin and Harvey Rosen (1990) found that “... if deductibility were eliminated,
the mean property tax rate in our sample would fall by 0.00715 ($7.15 per $1,000 of
assessed value), or 21.1% of the mean tax rate.”6
Deduction for Property Taxes
Under the federal income tax, taxpayers can deduct ad valorem property taxes
(taxes levied as a percentage of assessed value) from taxable income.7 For example,
an itemizing individual owning a home with an assessed value of $100,000, and who
pays a 1% property tax, can deduct the $1,000 tax from his or her adjusted gross
income. If this taxpayer is in the 28% marginal tax bracket, taking $1,000 out of
taxable income reduces taxes by $280 ($1,000 multiplied by 28%).8 In most cases,
both the taxpayer’s tax bracket and home value increase with income. Thus, higher-
income taxpayers in higher tax brackets receive a greater tax savings than low-
income taxpayers because of the typically progressive state income tax. The effect
is even greater because the assumed positive relationship between home value (and
property tax bill) and income.
H.R. 3221 (P.L. 110-289), the Housing and Economic Recovery Act of 2008,
signed by the President on July 30, 2008, includes a provision that allows non-
itemizers to deduct up to $500 ($1,000 for joint filers) of property taxes paid. The
special deduction is available for the 2008 tax year under the legislation.
Analysis. The property tax deduction was claimed on approximately 31% of
all tax returns. However, not all homeowners itemize, and only those who itemize
can take the deduction. In 2006 there were 72.3 million owner-occupied households
yet only 42.6 million taxpayers claimed an itemized deduction for real estate property
taxes in 2006.9 Table 1 above provides data for the years 1986, and 1997 through
2006 on the number of returns that claimed a property tax deduction, the most
common itemized deduction claimed.
Property taxes are a major source of local government revenue, and thus the
federal transfer through deductibility is also quite large. State governments, in
contrast, are less dependent upon property tax revenue and instead rely more upon
5 (...continued)
by Harvey Rosen, (Chicago: University of Chicago Press), pp. 137-176.
6 Douglas Holtz-Eakin and Harvey Rosen, “Federal Deductibility and Local Property Tax
Rates,” Journal of Urban Economics, vol. 27, 1990, pp. 269-284.
7 There are two types of property taxes, real estate (e.g., owner-occupied housing) and
personal (e.g., cars and boats). The focus of this report is the real estate property tax. For
ease of exposition, the modifier “real estate” is not used for the remainder of the report.
8 Marginal tax rates are sometimes referred to as tax brackets. There are currently six
individual income tax brackets: 10%, 15%, 25%, 28%, 33%, and 35%.
9 According to the U.S. Census Bureau, Current Housing Reports, Series H15/01, American
Housing Survey for the United States: 2006, (Washington: GPO, August, 2006).

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income and sales taxes. Nationally, property taxes comprised 45.2% ($347.3 billion
in FY2006) of all local government general own-source revenue and 1.2% ($11.8
billion in FY2006) of all state government general own-source revenue.10
Less than half of the combined $359.1 billion in property taxes collected by state
and local governments in FY2006 was deducted by individual taxpayers who
itemized on their federal income tax returns or by businesses as a business expense.
In 2006, $156.4 billion of real estate property taxes were claimed as itemized
deductions on individual federal income tax returns. Personal property taxes, such
as annual car taxes (based on the value of the car), generated $9.0 billion in
deductions in 2006. The amount collected and the amount deducted are different
because only one-third of taxpayers itemize on individual returns and businesses
(including landlords) pay a large share of property taxes that would not appear as
itemized deductions on individual income tax returns.
The federal tax expenditure estimated by the Joint Committee on Taxation
(JCT) approximates the amount of federal revenue lost (or approximately the amount
taxpayers benefit) as a result of the deductibility. Table 2 presents the tax
expenditure over the FY2007-FY2011 estimating window for taxpayers who claim
a deduction for state and local real estate property taxes. The five-year total
expenditure is estimated by the JCT to be approximately $87.1 billion. The annual
expenditure increases from $16.8 billion in 2007 to $27.9 billion in 2011. The
increase likely reflects the expiration of the lower marginal tax rates enacted in 2001.
Table 2. Estimated Federal Tax Expenditure on the
Real Estate Property Tax Deduction
(in $ billions)
2007
2008
2009
2010
2011
Total
Deduction for Property Taxes on Owner-
16.8
14.3
14.2
13.9
27.9
87.1
Occupied Housing
Source: U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for
Fiscal Years 2007-2011, joint committee print, JCS-03-07, 110th Congress (Washington: GPO, 2007).
In theory, if the property tax paid deduction were eliminated, taxpayers would
gradually reduce their level of housing consumption, and thus their property tax bill.
This shift would be gradual as housing consumption choices are not as responsive as
other expenditures to changes in after-tax price given the relatively illiquid nature of
housing assets. In addition, as noted earlier, state and local governments may lower
tax rates and shift to other revenue sources if the relative tax price of raising revenue
through property taxes increases. Local governments would have more at stake than
state governments, because the real property tax is primarily a local source of
revenue. Across taxpayers, high-income property owners in states with relatively
10 U.S. Census Bureau, State and Local Government Finances: 2005-06, the data are
available at [http://www.census.gov/govs/www/estimate06.html], visited July 16, 2008. The
property tax in the census data includes both real estate property taxes and personal property
taxes.

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high local property values (and taxes) would likely see the greatest increase in total
tax burden if property tax deductibility were repealed.
Deduction for Income Taxes
From 2004 through 2007, taxpayers who itemize may choose between deducting
either state and local income taxes or sales taxes, but not both. In 2008, the sales
deduction option is no longer allowed. As with local property taxes, the federal
deduction is equal to the taxpayer’s individual tax rate multiplied by the amount of
state and local income tax paid.11
The income tax is a source of revenue primarily for states, not local
jurisdictions. In FY2006, state governments collected $245.9 billion in individual
income taxes and local governments collected $22.7 billion ($268.6 billion
combined). Federal deductions claimed on federal income tax forms for both state
and local income taxes in the 2006 tax year totaled $246.4 billion. The difference
between what was collected and what was claimed on federal returns stems from
taxpayers who did not itemize or individuals who were not required to file federal
returns. Both groups are significantly more likely to be relatively low-income.
Two estimates of the tax expenditure for the deduction of state and local taxes
are included in Table 3. One estimate was calculated before the American Job
Creation Act (AJCA) of 2004 was enacted and the second is the most recent estimate
of the tax expenditure. In December of 2006, P.L. 109-432 was enacted, extending
the sales tax deduction option through 2007. Note that both of the annual tax
expenditure estimates below include the personal property tax deduction. The tax
expenditure generated by the personal property tax, however, is a small fraction of
the federal tax expenditure reported below. The Joint Committee on Taxation (JCT)
estimated that extending the deduction for sales tax options through 2008 would
reduce federal revenues by $2.3 billion over the 2008 to 2012 budget window.12
Analysis. The deduction for state and local income taxes affects the
distributional burden of both state and federal taxes. First, the deduction could
increase the progressivity of state taxes if it causes states to rely more on progressive
taxes such as the income tax. The cost of the deduction for high rate taxpayers is
effectively “exported” to all federal taxpayers. A state that collects a relatively larger
share of income taxes from taxpayers in high federal income tax brackets, is most
effective at exporting a portion of its state tax burden to all federal taxpayers.
11 In some states, taxpayers may also deduct federal income taxes from income when
calculating state taxable income. The reciprocal deduction, however, for federal income
taxes is practiced only in six states. Partial or limited deductibility is available in an
additional three states. Because few states offer the reciprocal deduction for federal income
taxes paid, the focus here is limited to the deductibility of state income taxes when
calculating federal taxable income.
12 U.S. Congress, Joint Committee on Taxation, Estimated Revenue Effects of the
Chairman’s Amendment in the Nature of a Substitute to H.R. 3996, the “Temporary Tax
Relief Act of 2007,” scheduled for markup by the Committee on Ways and Means on
November 1, 2007, JCX-105-07, 110th Congress, October 31, 2007.

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Table 3. Estimated Federal Tax Expenditure on the State and
Local Income, Sales, and Personal Property Tax Deductions
(in $ billions)
Pre-AJCA Estimate
2004
2005
2006
2007
2008
Total
Deduction for State and local Income &
Personal Property Taxesa
44.3
40.9
37.9
36.7
35.4
195.2
Most Recent Estimate
2007
2008
2009
2010
2011
Total
Deduction for State and local Income,
33.9
29.6
29.6
30.0
52.0
175.1
Sales, and Personal Property Taxesb
a. U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal
Years 2004-2008, joint committee print, JCS-08-03, 108th Congress (Washington: GPO, 2003).
b. U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal
Years 2007-2011, joint committee print, JCS-03-07, 110th Congress (Washington: GPO, 2007).
The federal tax burden, however, could be shifted to the majority of taxpayers
who do not itemize deductions. Before the alternative sales tax deduction was
enacted by AJCA, taxpayers in states without an income tax were more likely to be
non-itemizers; thus taxpayers in these states bore a relatively higher tax burden than
taxpayers in states with an income tax. The sales tax deductibility provision has
partially muted this shift in tax burden.
Deduction for Sales and Use13 Taxes
Explanation. The deduction for state and local sales taxes was temporarily
reinstated in 2004 with enactment of the AJCA and expired after the 2007 tax year.
Unlike the pre-TRA 1986 deduction, the AJCA version allowed for a deduction for
sales taxes in lieu of income taxes. Taxpayers may choose between reporting actual
sales tax paid, verified with saved receipts indicating sales taxes paid, or an estimated
amount found in tables provided by the IRS.14 The table amounts do not include the
sales taxes paid for cars, motorcycles, boats, aircraft, or a home, and local sales taxes
paid. Taxpayers may add taxes paid for these items to the table amount. Taxpayers
are asked to calculate the ratio of the local sales tax rate to the state sales tax rate,
then multiply the result by the table amount to arrive at an estimate of local sales
taxes paid. The estimated local sales taxes paid are then added to the state sales taxes
paid table amount. The provision expired on December 31, 2007.
Analysis. Allowing the deduction for state and local sales taxes in lieu of
income taxes likely diminishes the progressivity of the federal income tax system
because the deduction from income is available only to taxpayers who itemize.
Itemizers in states that do not impose an income tax benefit the most from the
13 A use tax is a tax on the use of a product. In the early years of the sales tax, states began
with general sales then added the use tax. The intent of the use tax is to capture the sales
tax due on purchases made out-of-state yet used in-state. Eventually, states adopting a sales
tax included the use tax in the enacting legislation.
14 See IRS publication 600, noted earlier.

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optional sales tax deduction (see Table 4, footnote “a” for these states). The gradual
reduction in allowable itemized deductions for wealthy taxpayers and the alternative
minimum tax (AMT) do limit the benefit at the highest end of the income
distribution.
It is also true that states without an income tax rely more on sales and property
taxes than do states with an income tax. As a result, itemizers in states without an
income tax will be able to deduct proportionately more of their state and local taxes
than taxpayers in states with both an income and sales tax. A shown in Table 4, in
states without an income tax, state and local governments rely on sales and property
taxes for 69.3% of total tax revenue. In contrast, in states that levy an income tax,
state and local governments rely on income and property taxes for 56.0% of total tax
revenue.
The differential treatment of states based on the reliance on the income tax was
likely unintended. Nevertheless, states without an income tax are considerably better
off with the sales tax deduction option relative to income tax states. As such,
extension of the sales tax deduction option would benefit non-income tax states
relatively more than other states.
Table 4. Type of Tax Revenue, Non-Income Tax States and
Income Tax States, FY2006
Type of tax revenue as percent of total state and local tax revenue
Non-income tax
Income tax states
Type of tax
All states and DC
statesa
and DC
Total
100.0%
100.0%
100.0%
Property tax
30.0%
35.8%
28.8%
General sales
23.6%
33.5%
21.5%
Individual income
22.5%
0.1%
27.2%
Other taxes
23.9%
30.5%
22.5%
Maximum deductible
58.3%
69.3%
56.0%
Source: CRS calculations based on Census Bureau data. FY2006 is the latest year for which data are
available by individual states.
a. Includes AK, FL, NH, NV, SD, TN, TX, WA, and WY. The income tax percentage is positive
for states without an income tax because New Hampshire and Tennessee levy an income tax on
dividend and interest income (or capital income).
Policy Alternatives and Current Legislation
The President’s Advisory Panel on Federal Tax Reform proposed eliminating
the state and local tax deduction as part of comprehensive tax reform. Eliminating
deductibility of state and local taxes would affect the distributional burden of federal,
state, and local taxes. Other provisions in the tax reform panel’s recommendations
would interact with the elimination of the deduction for state and local taxes paid.
The magnitude of the impact would depend significantly on the response of state and
local governments to the federal changes.

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In the 110th Congress, 11 bills have been introduced that would make the sales
tax deduction permanent: H.R. 60, H.R. 411, H.R. 2734, H.R.3592, H.R. 3906, H.R.
4086, H.R. 5242, H.R. 5744, S. 143, S. 180, and S. 2233. Four bills, H.R. 3680,
H.R. 3970, H.R. 6049, and S. 3335 would extend the sales tax deduction option for
one year. H.R. 6049 passed in the House on May 21, 2008. S. 2886 would extend
the sales tax deduction option for two years, through 2009.
As described earlier, Congress has also turned attention to property taxes paid
by non-itemizers. H.R. 3221 (P.L. 110-289), the Housing and Economic Recovery
Act of 2008, signed by the President on July 26, 2008, includes a provision that
allows non-itemizers to deduct up to $500 ($1,000 for joint filers) of property taxes
paid. The special deduction is available for the 2008 tax year under the legislation.
Federal Tax Base Broadening: Eliminate Deductibility of State and
Local Taxes. If deductibility were eliminated and state and local governments are
policy neutral (i.e., do nothing in response to the federal changes), then the impact
on the distributional burden of state and local taxes will remain essentially
unchanged. The federal tax burden, however, will shift from low tax state taxes
toward high tax states. Under current tax rules, taxpayers in high tax states can
deduct more from federal income than can those in low tax states.15
For example, potentially deductible state and local taxes in New York comprise
approximately 8.8% of total personal income whereas deductible taxes in nearby
Delaware account for approximately 4.8% of total personal income.16 Thus,
taxpayers in New York can deduct significantly more from federal income than can
taxpayers in Delaware.
Assuming that other federal taxes were maintained after the elimination of the
federal deduction for state and local taxes, the tax burden would shift toward high-tax
states from low-tax states. If the federal government reduces tax rates to maintain
revenue neutrality — the base is larger with the elimination of the deductibility
allowing for lower rates to yield the same revenue — then the effect is even more
pronounced. The higher the state and local tax burden (as percentage of total
income), the lower the new federal tax rate would be under revenue neutrality.
More generally, if state and local tax deductibility were eliminated, the federal
tax burden would shift from all federal taxpayers toward itemizers. As noted earlier,
itemizers tend to be higher income, thus, federal income taxes may become more
progressive if the state and local taxes paid deduction were eliminated.
15 The tax reform panel reform package would counter, or at least offset, the distributional
effect of the state and local taxes paid deduction through elimination of the AMT and the
highest tax bracket.
16 State personal income data are from the U.S. Census Bureau, Bureau of Economic
Analysis, available at [http://www.bea.gov/newsreleases/regional/spi/spi_newsrelease.htm],
visited on July 17, 2008. State tax data are from U.S. Census Bureau, State and Local
G o v e r n m e n t F i n a n c e s : 2 0 0 5 - 0 6 , t h e d a t a a r e a v a i l a b l e a t
[http://www.census.gov/govs/www/estimate06.html], visited July 16, 2008.

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Some secondary effects, however, are anticipated at the state and local level.
If deductibility were eliminated, state and local governments might be less willing
to finance projects that generate benefits that extend beyond the taxing jurisdiction.
The tax price to a community of these projects would increase as the federal
“contribution” through deductibility is lost. Projects and initiatives whose benefits
extend beyond the local jurisdiction would likely be the most sensitive to changes in
the tax price as the benefits are more widely dispersed.17 A reduction in state and
local public good provision may adversely affect low-income individuals relative to
high-income individuals.
Quantifying the magnitude of the state and local spending response is difficult
because many other factors influence state and local spending decisions such as state
and local political considerations and overall economic conditions. Nevertheless,
most research has found that state spending declines or would decline, but by how
much? Before sales tax deductibility was eliminated in 1987, one researcher
estimated that “... the overall responses are on the order of zero to ten percent, much
less than estimates used in the political debate.”18 In contrast, another economist
found that the “... level of state and local spending is significantly affected by
deductibility.”19
Making the Sales Tax Deduction Permanent. Under the AJCA, the sales
tax deduction expired January 1, 2006. On December 20, 2006, the deduction was
extended through 2007 by the Tax Relief and Health Care Act of 2006 (P.L. 109-
432). Making the provision permanent would benefit itemizing taxpayers in states
without an income tax the most. The cost of making the sales tax deduction option
permanent (continuing with the in lieu of income taxes language) would generate an
annual federal revenue loss of approximately $37.1 billion over the FY2009 to
FY2018 budget window ($3.0 billion in FY2009).20
Other Policy Considerations. Two concepts or issues were not directly
addressed in this report yet will likely arise during the debate surrounding the federal
income tax treatment of state and local taxes. One, are the tax expenditures for state
and local taxes paid truly federal tax “expenditures?” Or, do these “expenditures”
represent a return of taxpayer income that was never the federal government’s to
begin with? Two, would the absence of a federal deduction for state and local taxes
paid amount to “taxing a tax?” The foundation of these arguments can be traced to
the difference between a theoretically ideal income tax and the federal income tax as
it currently exists.
17 Robert Jay Dilger, “Eliminating the Deductibility of State and Local Taxes: Impacts on
States and Cities,” Public Budgeting & Finance, winter 1985, p. 77.
18 Edward M. Gramlich, “The Deductibility of State and Local Taxes,” National Tax
Journal, vol. 38, no. 4, December 1985, p. 462.
19 Lawrence B. Lindsey, “Federal Deductibility of State and Local Taxes,” in Harvey Rosen,
editor, Fiscal Federalism: Quantitative Studies (Chicago, IL: University of Chicago Press,
1988), p. 173.
20 Congressional Budget Office, The Budget and Economic Outlook: Fiscal Years 2008 to
2018, January 2008, p.101.

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CRS-12
The ideal federal income tax would include wage income plus all accretions to
wealth (including imputed income) over a designated time period, one calendar year,
for example.21 This definition of income should, theoretically, accurately measure
an individual’s ability to pay income taxes. Any exclusions or deductions from this
definition of income would represent a departure from the rule and thus generate a
tax “expenditure” or federal subsidy.
There are two ways to view taxes paid for state and local government services
under an ideal income tax.22 If one views state and local taxes paid as payment for
government provided services which could be privately provided, then the federal
deduction for state and local taxes is not appropriate. In contrast, if one views state
and local taxes as lost income resulting in a reduced ability to pay federal income
taxes (a loss), then a deduction for those taxes seems reasonable. The more tangible,
less theoretical, tax-on-a-tax issue arises from this last observation.23
There is not a clear consensus on which view is “correct.” For some state and
local taxes and taxpayers, the fee-for-specific-services view is more accurate.
Taxpayers with government-provided trash collection who pay property taxes for
government spending on trash collection, for example, are receiving a tangible quasi-
private benefit. Similar federal taxpayers in two otherwise equivalent jurisdictions
— except that one provides garbage collection and one does not — would face
different federal tax burdens. Generally, this would contradict the concept of
horizontal equity across federal taxpayers.
The reduction-in-ability-to-pay view seems more reasonable for those paying
general sales taxes for general government provision of public goods such as fire and
police protection. Note that a federal deduction for sales taxes and not property taxes
would theoretically seem more desirable.
President’s Advisory Panel on Federal Tax Reform. The tax reform
panel has recommended elimination of the deduction for all state and local taxes as
part of a broader effort to simplify the tax code. Under the reform plan, the repeal
of the deduction would be accompanied by repeal of the alternative minimum tax
(AMT), a switch from personal exemptions and a standard deduction to a family
credit, and a lower top marginal tax rate. Each of the additional proposals affect the
overall impact of state and local deductibility repeal. As outlined earlier in this
report, under current law, the deductibility benefits itemizers in high-tax jurisdictions
more than non-itemizers in low-tax jurisdictions. Thus, elimination of the deduction
21 This definition of an ideal income tax is credited to Haig and Simons, who did much of
their research in the 1930s. For more, see Simons, Henry Calvert, Personal Income
Taxation: The Definition of Income as a Problem of Fiscal Policy (Chicago, IL: University
of Chicago Press, 1938).
22 Note that the benefits received by taxpayers are not included in federal taxable income.
23 When top federal income tax rates were much higher in the 1970s and 1980s (the top rate
was 70% in 1981), it is true that combined with state and local rates of 10% to 15% would
create almost confiscatory cumulative income tax rates. The current federal rate structure
with much lower rates minimize this effect.

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CRS-13
would shift the burden from low-income taxpayers to high-income taxpayers, all else
held constant.
Elimination of the AMT and a lower top regular income tax rate, however, will
benefit primarily high-income taxpayers. Note that AMT filers cannot take the
deduction for state and local taxes paid, thus elimination of the deduction is mostly
inconsequential. The elimination of the 10% bracket amount and the narrower 28%
income tax bracket will increase taxes for all taxpayers. Low-income taxpayers will
likely encounter a greater increase in relative tax burden (based on taxes as a
percentage of income) under the tax reform plan. Thus, on balance, the tax reform
panel package of tax code changes, taken together, may not significantly shift the
federal tax burden.
The proposed tax reform plan(s) will also have an indirect effect on state and
local government finances if implemented. Federal income taxes will not vary based
on the residence of the itemizing taxpayer as is currently the case. Some may argue
that the “neutral” treatment of all taxpayers, regardless of state and local tax burden,
may be inequitable because taxpayers in high-tax jurisdictions have a reduced ability
to pay federal income taxes. Alternatively, others argue that the federal income tax
should be neutral with regard to state and local taxes. Nevertheless, the use of
uniform credits will increase the relative price of state and local government services.
High-tax/high-government-service jurisdictions would fare less well than low-
tax/low-government-service jurisdictions.
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