Federal Deductibility of State and Local Taxes
Steven Maguire
Section Research Manager
Jeffrey M. Stupak
Research Assistant
November 10, 2014
Congressional Research Service
7-5700
www.crs.gov
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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 was available, through
December 31, 2013. The federal deduction for state and local taxes results in the federal
government paying part of these state and local 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 these
deductions. 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 taxpayers in low-tax states to taxpayers in high-tax
states. Maintaining the current deductibility would continue the indirect federal subsidy for state
and local spending.
Expanding deductibility, such as reinstating 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. The American
Taxpayer Relief Act of 2012 (P.L. 112-240) extended the sales tax deduction option through the
2013 tax year, but it has since been allowed to expire.
In the 111th Congress, the American Recovery and Reinvestment Act (P.L. 111-5) provided for an
above-the-line deduction for sales and excise taxes paid on new vehicle purchases for non-
itemizers which has since expired.
The President’s FY2015 budget proposed a limit on the tax rate (generally a 28% marginal tax
rate) at which itemized deductions would reduce tax liability, but did not specifically address
deductions related to state and local taxes. A number of bills have been introduced in the 113th
Congress, in both the House (H.R. 2854, H.R. 3942, H.R. 4469, and H.R. 4789) and Senate (S.
41, S. 127, S. 1859, and S. 2260) by Republicans and Democrats that would extend the state and
local sales tax deduction permanently or temporarily.
This report will be updated as legislative events warrant.
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Federal Deductibility of State and Local Taxes
Contents
Introduction ...................................................................................................................................... 1
Brief History .................................................................................................................................... 1
Deductible State and Local Taxes .................................................................................................... 3
Deduction for Real Estate Property Taxes ................................................................................. 4
Analysis ............................................................................................................................... 5
Deduction for Income Taxes ...................................................................................................... 6
Analysis ............................................................................................................................... 7
Deduction for Sales and Use Taxes ........................................................................................... 7
Explanation ......................................................................................................................... 7
Analysis ............................................................................................................................... 8
Policy Alternatives and Current Legislation .............................................................................. 9
Federal Tax Base Broadening: Eliminate Deductibility of State and Local Taxes .............. 9
Making the Sales Tax Deduction Permanent ..................................................................... 11
Other Policy Considerations .............................................................................................. 11
Tables
Table 1. Number and Percentage of State and Local Taxes Paid Itemizers, 1986 and 2002
to 2012 .......................................................................................................................................... 3
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 ................................................................................................ 7
Table 4. Type of Tax Revenue, Non-Income Tax States and Income Tax States, FY2011 .............. 9
Contacts
Author Contact Information........................................................................................................... 12
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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 state and local income
taxes paid from federal taxable income. In 2004, the 108th Congress modified the deductibility of
state and local taxes to include sales tax for the 2004 and 2005 tax years. This provision was
extended by each Congress up through the 112th, until it was allowed to expire at the end of 2013.
The Administration’s FY2015 budget proposal does not provide for an extension of the sales tax
deduction option. However, multiple bills to extend the sales tax deduction option permanently or
temporarily have been introduced into both the House and Senate during the 113th Congress.
Legislation that would extend the sales tax deduction option permanently includes H.R. 2854,
H.R. 4789, S. 41, and S. 127. A one-year extension (for 2014) has been proposed by H.R. 3942,
H.R. 4469, and S. 1859. S. 2260 would extend the sales tax deduction option through 2015.
In addition to the sales tax deduction option, Congress previously enacted a provision that
allowed non-itemizers to deduct up to $500 ($1,000 for joint filers) of property taxes paid. The
special deduction was available for the 2008 and 2009 tax years and was in response to the
housing crisis. Unlike the sales tax deduction option, the special property tax deduction was not
extended beyond 2009. The tax savings from the special property tax deduction likely benefited
taxpayers that did not have other potentially deductible expenses that were high enough to merit
itemizing. Taxpayers with no mortgage (or low mortgage debt) in states with relatively low state
and local tax burdens were the most likely to have benefited the most from this expired tax
provision.
In the 111th Congress, the American Recovery and Reinvestment Act (P.L. 111-5) provided for an
above-the-line deduction for sales and excise taxes paid on new vehicle purchases for non-
itemizers. This deduction also expired after the 2009 tax year.
Brief History
The deduction from federal income for state and local taxes paid originates from 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
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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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 deduction for sales taxes 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
• 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 expired 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 sales tax
deduction option was extended through the 2009 tax year by the Emergency Economic
Stabilization Act of 2008 (P.L. 110-343). The Tax Relief, Unemployment Insurance
Reauthorization, and Job Creation Act of 2010 (P.L. 111-312), extended the sales tax deduction
option through the 2011 tax year. And finally, the American Taxpayer Relief Act (P.L. 112-240)
extended the sales tax deduction option through the 2013 tax year. This provision has since been
allowed to expire.
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)
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.
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sales and use taxes. As Congress considers possible reinstatement 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 paid from income. Individual taxpayers,
however, must itemize deductions (rather than use the standard deduction) on their income tax
return to claim the deduction for state and local 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. For example, in
2010, 88% of all benefits from the deduction of state and local taxes paid went to individuals with
adjusted gross incomes greater than $100,000.5 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.
Table 1. Number and Percentage of State and Local Taxes Paid Itemizers,
1986 and 2002 to 2012
(return numbers in millions)
1986 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
Al
Returns
103.0 130.1 130.4 132.2 134.4 138.4 143.0 142.5 140.5 142.9 145.4 144.9
Itemized
Deductions 40.7 45.6 43.9 46.3 47.8 49.1 50.5 48.2 45.7 46.6 46.3 45.6
State
and
local
taxes 40.4 44.8 43.1 44.8 46.0 46.9 48.6 46.4 44.0 44.9 44.6 43.9
Income
tax
33.2 37.6 35.9 33.5 34.6 35.7 36.7 35.4 33.8 33.5 33.7 33.4
General
sales
tax
39.0 n/a n/a 11.2 11.4 11.2 11.9 11.0 10.3 11.4 10.9 10.5
Real estate property
32.9 39.7 38.3 40.5 41.3 42.6 43.6 41.6 40.0 41.0 40.1 39.3
taxes
Personal property
11.5 20.6 20.0 21.1 21.3 21.5 22.1 21.0 16.1 17.2 19.9 19.9
taxes
Other
9.1 3.4 3.2 3.0 2.8 3.1 2.9 2.8 5.4 5.2 2.6 2.5
taxes
New
Motor
Vehicle
- - - - - - - - 2.2
0.3 - -
Al
Returns
100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100%
Itemized
Deductions 39.5 35.1 33.7 35.0 35.5 35.5 35.4 33.8 32.5 32.6 31.8 31.5
State
and
local
taxes 39.2 34.4 33.0 33.9 34.2 33.9 34.0 32.6 31.3 31.4 30.7 30.3
Income
tax
32.2 28.9 27.6 25.3 25.7 25.8 25.7 24.9 24.0 23.4 23.2 23.1
4 A progressive tax is one in which the rate of tax increases with income.
5 Rueben, Kim and K. Stark, “In Pursuit of Revenue: Federal Income Tax Reform,” The CPA Journal, November 2013,
p. 20.
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1986 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012
General
sales
tax 37.8 n/a n/a 8.5 8.5 8.1 8.3 7.8 7.3 8.0 7.5 7.2
Real estate property
32.0 30.5 29.4 30.6 30.7 30.8 30.5 29.2 28.5 28.7 27.6 27.1
taxes
Personal property
11.1 15.8 15.4 15.9 15.8 15.5 15.4 14.7 11.5 12.0 13.7 13.7
taxes
Other
8.8 2.6 2.4 2.3 2.1 2.2 2.0 2.0 3.9 3.7 1.8 1.7
taxes
New
Motor
Vehicle
- - - - - - - - 1.6
0.2 - -
Source: U.S. Department of Treasury, Internal Revenue Service, Statistics of Income Division, Individual Income Tax
Returns, various years, Publication 1304.
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, before repeal, 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 owning property, real or personal. The current sales tax deduction is
not as common because it is in lieu of income taxes. In 2012, 10.5 million or 7.2% of taxpayers
claimed a deduction for sales taxes paid, and the percentage of taxpayers who claimed a
deduction for income taxes paid has dropped from 25.8%in 2006 to 23.1% in 2012.
The percentage of itemizers has remained relatively stable since 2002 (see Table 1) may exhibit
income growth that 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 likely is in response to the
lower marginal tax rates and more generous standard deduction for married taxpayers filing joint
returns. The total number (and percentage) of itemizers increased from 43.9 million in 2003 to
46.3 million in 2004, likely reflecting the introduction of the sales tax deduction option. The
decline in 2009 may be related to the economic downturn that began in 2008. Generally, however,
the percentage of itemizers and the taxes they deduct has been generally consistent since 2002.
Deduction for Real Estate 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.6 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 in taxes paid 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%).7 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
6 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.
7 Marginal tax rates are sometimes referred to as tax brackets. There are currently seven individual income tax brackets:
10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
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taxpayers because of the typically progressive state income tax. The effect is even greater because
of the assumed positive relationship between home value (and property tax bill) and income.
In the 110th Congress, P.L. 110-289 included a provision that allowed non-itemizers to deduct up
to $500 ($1,000 for joint filers) of property taxes paid. The special deduction was first available
for the 2008 tax year and was extended through 2009 by P.L. 110-343. This special deduction has
since expired.
Analysis
The real estate property tax deduction was claimed on approximately 27.1% of all tax returns, and
of those returns that itemized, approximately 86% claimed a real estate property tax deduction in
2012. Table 1 above provides data for the years 1986, and 2002 through 2012 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 income and sales taxes. Nationally, property
taxes comprised 47.4% ($429.1 billion in FY2011) of all local government general own-source
revenue and 1.3% ($14.2 billion in FY2011) of all state government general own-source revenue.8
Less than 40% of the combined $443.3 billion in property taxes collected by state and local
governments in FY2011 was deducted by individual taxpayers who itemized on their federal
income tax returns or by businesses as a business expense.9 In 2011, $173.0 billion of real estate
property taxes paid were claimed as itemized deductions on individual federal income tax
returns.10 In 2009, an additional 15.7 million non-itemized returns were filed that claimed $11.3
billion in deductions for real estate taxes paid, as part of the temporary additional standard
deduction. Personal property taxes, such as annual car taxes (based on the value of the car),
generated $8.3 billion in deductions in 2011. The amount collected and the amount deducted
differ because only about 31% 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.11
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 FY2014-FY2018 estimating
window for taxpayers who itemize and claim a deduction for state and local real estate property.
The five-year total expenditure is estimated by the JCT to be approximately $182.1 billion. The
annual expenditure for deduction by itemizers increases from $31.9 billion in 2014 to $41.0
8 U.S. Census Bureau, State and Local Government Finances: 2011, the data are available at https://www.census.gov/
govs/local/, accessed September 15, 2014. The property tax in the census data includes both real estate property taxes
and personal property taxes.
9 Ibid. Department of the Treasury, Internal Revenue Service, “2011 Estimated Data line Counts Individual Income Tax
Returns,” Rev. 09-2013, September, 2013, at http://www.irs.gov/pub/irs-soi/11inlinecount.pdf.
10 Ibid.
11 U.S. Department of Treasury, Internal Revenue Service, Statistics of Income Division, “Individual Income Tax
Returns, various years,” Publication 1304.
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billion in 2018. The increase likely reflects the current economic recovery and increasing housing
prices.
Table 2. Estimated Federal Tax Expenditure on the
Real Estate Property Tax Deduction
(in $ billions)
2014
2015
2016
2017
2018 Total
Deduction for Property Taxes on Owner-Occupied Housing
31.9
34.0
36.4
38.8
41.0
182.1
Source: U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2014-2018,
joint committee print, JCX-97-14, 112th Congress (Washington: GPO, 2014).
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 would also change. 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
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
Through 2013, taxpayers who itemized could choose between deducting either state and local
income taxes or general sales taxes, but not both. However, the deductibility of general sales
taxes expired at the end of 2013. As with local property taxes, the federal deduction for state and
local income taxes is equal to the taxpayer’s individual tax rate multiplied by the amount of state
and local income tax paid.12
The income tax is a source of revenue primarily for states, not local jurisdictions. In FY2011,
state governments collected $259.3 billion in individual income taxes and local governments
collected $25.6 billion ($285.0 billion combined).13 Federal deductions claimed on federal
income tax forms for both state and local income taxes in the 2011 tax year totaled $266.0
billion.14 The difference between what was collected and what was claimed on federal returns
12 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.
13 U.S. Census Bureau, State and Local Government Finances: 201107-08, the data are available at
https://www.census.gov/govs/local/, accessed September 15, 2014.
14 Internal Revenue Service, “2011 Estimated Data line Counts Individual Income Tax Returns,” Rev. 09-2013,
September, 2013, at http://www.irs.gov/pub/irs-soi/11inlinecount.pdf.
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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.
Estimates of the tax expenditure for the deduction of state and local taxes are included in Table 3.
In December of 2010, the Tax Relief, Unemployment Insurance Reauthorization, and Job
Creation Act of 2010 (P.L. 111-312) extended the sales tax deduction option through 2011, and
the American Taxpayer Relief Act of 2012 (ATRA; P.L. 112-240) again extended the provision
through 2013. Note that 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.
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.
Table 3. Estimated Federal Tax Expenditure on the State and Local Income, Sales,
and Personal Property Tax Deductions
(in $ billions)
2014 2015 2016 2017 2018 Total
Deduction for state and local government Income, Sales,
56.5 59.2 63.0 66.9 70.7 316.4
and Personal Property taxes
Source: U.S. Congress, Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2014-
2018, joint committee print, JCX-97-14, 112th Congress (Washington: GPO, 2014).
The federal tax burden, however, could be shifted to the majority of taxpayers who do not itemize
deductions. Due to the expiration of the alternative sales tax deduction, taxpayers in states
without an income tax are more likely to be non-itemizers; thus taxpayers in these states bear a
relatively higher tax burden than taxpayers in states with an income tax. The sales tax
deductibility provision had partially muted this shift in tax burden.
Deduction for Sales and Use Taxes15
Explanation
The deduction for state and local sales taxes was temporarily reinstated in 2004 with enactment of
the AJCA. This provision was extended a number of times before being allowed to expire at the
end of 2013, after being most recently extended by ATRA in 2012. Unlike the pre-TRA 1986
15 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.
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deduction, the most recent version allowed for a deduction of sales taxes in lieu of income taxes,
as opposed to in addition to. Taxpayers who itemized could choose between reporting actual sales
tax paid, verified with receipts indicating sales taxes paid, or an estimated amount from tables
provided by the IRS.16 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, and 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, 2013. As noted earlier,
multiple bills introduced into both the House and Senate would permanently extend this
provision.
The American Recovery and Reinvestment Act (ARRA, P.L. 111-5) included a special deduction
for the sales tax and excise tax paid on new vehicle purchases through 2009. This deduction was
available only for those taxpayers that chose not to claim a deduction for general sales taxes paid.
Thus, both non-itemizers and itemizers claiming a state or local income tax deduction could take
this special deduction. The dollar value of the deduction is limited in two ways. First, only the
first $49,500 of the purchase price is eligible and second, the deduction is phased out for
taxpayers with adjusted gross income between $125,000 and $135,000 (for joint filers the phase-
out range is $250,000 to $260,000).
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 for two reasons. Firstly, the deduction from income
is available only to taxpayers who itemize.17 Secondly, this provision takes the form of a
deduction, as opposed to a credit, so that the value of the deduction is greater for individuals
facing higher income tax rates. Itemizers in states that do not impose an income tax (and also levy
a sales tax) benefited the most from the 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) limited the benefit at the highest end of the income
distribution.
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 could deduct proportionately more of
their state and local taxes than taxpayers in states with both an income and sales tax. As shown in
Table 4, in states without an income tax, state and local governments rely on sales and property
taxes for 70.7% of total tax revenue. In contrast, in states that levy an income tax, state and local
governments rely on income and property taxes for 57.8% 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, reinstatement of the sales tax deduction option
would benefit non-income tax states relatively more than other states.
16 See IRS publication 600, noted earlier.
17 The special deduction for sales and excise taxes in 2009 likely returned some progressivity to the tax system.
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Table 4. Type of Tax Revenue, Non-Income Tax States and Income Tax States, FY2011
Type of tax revenue as percent of total state and local tax revenue
Type of tax
All states
Income tax states and DC
Non-income tax statesa
Total 100%
100% 100%
Property tax
33%
32%
38%
General sales
23%
21%
32%
Individual income
21%
26%
0%
Corporate income
4%
4%
2%
Other taxes
19%
18%
27%
Maximum deductible
54%
58%
39%
Source: CRS calculations based on Census Bureau data for FY2011.
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). New Hampshire does not levy a sales tax and Alaska does not levy a statewide
sales tax.
Policy Alternatives and Current Legislation
The President’s FY2015 budget plan proposed limiting the tax rate at which itemized deductions
would reduce tax liability. This proposal would reduce the value of the deduction for state and
local taxes for upper income individuals. Under current law, the value of an itemized deduction is
the taxpayer’s marginal tax rate multiplied by the amount of the taxes paid. The Administration’s
proposal would cap the value of the deduction at 28% multiplied by the amount of the taxes
paid.18 Clearly, the cap would not affect taxpayers at or below the 28% rate. For the 2014 tax
year, the two higher rates are 35% and 39.6%.
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.19
For example, in 2011, potentially deductible state and local taxes in New York comprised
approximately 8.9% of total personal income whereas deductible taxes in nearby Delaware
accounted for approximately 4.9% of total personal income.20 Thus, taxpayers in New York can
deduct significantly more from federal income than can taxpayers in Delaware.
18 The interaction with the AMT would further reduce the value of the deductions that are preference items under the
AMT such as the deduction for state and local taxes.
19 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.
20 State personal income data are from the U.S. Census Bureau, Bureau of Economic Analysis, available at
(continued...)
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Federal Deductibility of State and Local Taxes
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. Some have estimated that individual income tax rates could be
reduced by 50% after the elimination of state and local tax deductibility, while remaining revenue
neutral.21 The higher the state and local tax burden (as a 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 deduction for state and
local taxes were eliminated. Estimates suggest that after-tax income for upper-income individuals
could decrease by an estimated 2.9% with the elimination of state and local tax deductions, while
lower-income individuals would see no change in their after-tax income.22
If the deductibility of state and local taxes were eliminated, some secondary effects would likely
occur 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 their taxing
jurisdiction. The tax price to a community of these projects would increase as the federal
“contribution” through deductibility is lost. These projects and initiatives would likely be the
most sensitive to changes in the tax price as the benefits are more widely dispersed.23 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, however, 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.”24 In contrast, another
economist found that the “level of state and local spending is significantly affected by
deductibility.”25
(...continued)
http://www.bea.gov/newsreleases/regional/spi/spi_newsrelease.htm, visited on July 30, 2010. State tax data are from
U.S. Census Bureau, State and Local Government Finances: 2007-08, the data are available at http://www.census.gov/
govs/www/estimate.html, visited July 30, 2010.
21 Jane Gravelle , “Practical Tax Reform for a More Efficient Income Tax,” Virginia Tax Review, vol. 30 (Summer
2010), p. 392.
22 Leonard Burman, Christopher Geissler, and Eric Toder, “How Big are Total Individual Income Tax Expenditures,
and Who Benefits From Them?,” American Economic Review, vol. 98, no. 2 (May 2008), pp. 79-83.
23 Robert Jay Dilger, “Eliminating the Deductibility of State and Local Taxes: Impacts on States and Cities,” Public
Budgeting & Finance, winter 1985, p. 77.
24 Edward M. Gramlich, “The Deductibility of State and Local Taxes,” National Tax Journal, vol. 38, no. 4, December
1985, p. 462.
25 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.
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Federal Deductibility of State and Local Taxes
In addition to possible spending changes, some researchers have found preliminary empirical
evidence that state taxes became more progressive in response to changes in the federal tax
structure. As part of the tax reforms of the 1980s individual income tax rates were reduced
significantly—top marginal rates were reduced from 70% in 1980 to 28% in 1988—which
effectively reduced the value of the deduction for state and local taxes. States responded to this
change by reducing statutory tax rates, but did not fully reverse the increase in progressivity in
the effective state tax burden resulting from the changes at the federal level.26
Making the Sales Tax Deduction Permanent
Making the sales tax deduction option 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 likely generate an annual federal
revenue loss of approximately $3.2 billion, which is the annual cost of a two-year extension.27
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.
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.28 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.29 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.30
26 Kim Rueben and Kirk Stark, Federal Tax Reform and the Deduction for State and Local Taxes , Tax Policy Center
Working Paper, 2012, pp. 13-14.
27 U.S. Congress, Joint Committee on Taxation, Estimated Revenue Effects of the Chairman’s Modification to the
“Expiring Provisions Improvement Reform and Efficiency Act of 2014,” JCX-32-14, April 3, 2014.
28 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).
29 Note that the benefits received by taxpayers are not included in federal taxable income.
30 Top federal income tax rates were much higher in the 1970s and 1980s (the top rate was 70% in 1981), and,
combined with state and local rates of 10% to 15%, created almost confiscatory cumulative income tax rates. The
current federal rate structure with much lower rates minimizes this effect.
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Federal Deductibility of State and Local Taxes
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 jurisdiction provides garbage collection and the other
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.
Author Contact Information
Steven Maguire
Jeffrey M. Stupak
Section Research Manager
Research Assistant
smaguire@crs.loc.gov, 7-7841
jstupak@crs.loc.gov, 7-2344
Congressional Research Service
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