Key Issues in Tax Reform: the Deduction for State and Local Taxes

Key Issues in Tax Reform: the Deduction for State and Local Taxes

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Updated November 14, 2017
Key Issues in Tax Reform: the Deduction for State and Local
Taxes
A key component of tax reform proposals is their treatment
income above certain thresholds ($313,800 for married
of federal tax expenditures or revenue losses attributable to
taxpayers filing jointly and $261,500 for single filers in
provisions that adjust income taxes away from a
2017).
“theoretically normal” tax system. Tax reform proposals in
the 115th Congress include modifications to the federal
Internal Revenue Service (IRS) data indicate that of the
deduction for state and local taxes, which is among the
44.6 million taxpayers who itemized deductions in 2015,
largest tax expenditures in the federal income tax system.
42.7 million (or 95.8% of itemizers) claimed deductions for
Debate over modifications to the current state and local tax
state and local taxes paid. Table 1 shows 2015 state and
deduction includes discussion of issues related to the
local deduction claim levels and rates as a percentage of all
interaction between federal, state, and local governments,
tax returns. A December 2016 estimate from the Joint
along with the distribution of the total tax burden across
Committee on Taxation (JCT) projected that under current
jurisdictions and households.
law, the federal deduction for state and local taxes would
reduce revenues by $548.8 billion from FY2016 to FY2020.
Current Law
Deductions for income taxes, sales taxes, and personal
Generally, taxpayers may deduct state and local taxes paid
property taxes were estimated to reduce revenues by $368.8
from income when filing a federal tax return. Individual
billion, while deductions for real property taxes were
taxpayers must itemize deductions (rather than use the
projected to reduce revenues by $180.0 billion over the
standard deduction) on their income tax return to claim the
five-year period.
deduction for state and local taxes paid. The federal tax
savings from the deduction on state and local taxes paid is
Legislative Background
equal to the taxpayer’s marginal tax rate multiplied by the
The federal income tax deduction for state and local taxes
size of the deduction.
paid originates from the Revenue Act of 1913, which
allowed the deduction for “all national, State, county,
Table 1. Number and Percentage of Returns with
school and municipal taxes paid within the year, not
State and Local Tax Deductions, Tax Year 2015
including those assessed against local benefits.” There were
(return numbers in millions, percentages of al returns)
frequent modifications to the deductibility provision over
the years, including the introduction of a sales tax deduction
Return Type
Number
% in 1932, the introduction of the standard deduction in 1944,
and the restriction of deductions to taxes explicitly
All Returns
150.5
100
mentioned in statute in 1964. Recent changes include repeal
Returns with Standard Deduction
105.9
70.4
of the deduction for sales taxes by the Tax Reform Act of
1986 (P.L. 99-514), temporary instatement of a deduction
Returns with Itemized Deductions
44.6
29.6
for sales taxes in lieu of income taxes by the American Jobs
Returns with deductions for:
Creation Act of 2004 (AJCA 2004, P.L. 108-357), and
permanent incorporation of the sales taxes deduction in lieu
Any State and Local Tax
42.7
28.4
of income taxes by the Consolidated Appropriations Act,
Real Property Taxes
37.6
25.0
2016 (P.L. 114-113).
Income Taxes
33.1
22.0
Recent Reform Proposals and Options
Repeal of the federal deduction for state and local taxes is
Personal Property Taxes
18.9
12.5
under consideration as part of tax reform proposals in the
Sales Taxes
9.6
6.4
115th Congress. H.R. 1, as reported by the Committee on
Ways and Means, would repeal the deductions for state and
Other State and Local Taxes
2.7
1.8
local income and sales taxes paid. H.R. 1 would also limit
Source: U.S. Department of the Treasury, Internal Revenue Service,
individual claims on state and local property taxes paid to
Statistics of Income Division, Individual Income Tax Returns, various
$10,000. That modification would not apply to taxes paid or
years, Publication 1304.
accrued in carrying on a trade or business. Conversely, the
Senate Finance Committee chairman’s mark to the “Tax
Qualifying taxpayers may claim deductions for state and
Cuts and Jobs Act” as scheduled for markup the week of
local real estate taxes, personal property taxes, income
November 13, 2017, would repeal all deductions for state
taxes, and sales taxes (in lieu of income taxes) from federal
and local taxes paid for individuals while retaining the
income when calculating taxable income. The rate of most
deductions for taxes paid or accrued in carrying on a trade
deductions is reduced for taxpayers with adjusted gross
or business.
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link to page 2 Key Issues in Tax Reform: the Deduction for State and Local Taxes
H.R. 1 and the Senate Finance Committee chairman’s mark
personal income in Florida and approximately 13.8% of
to the “Tax Cuts and Jobs Act” would each increase the
total personal income in New York. Thus, the average
standard deduction. An adjustment to the standard
taxpayer in New York can deduct significantly more from
deduction not paired with a direct modification to the state
federal income than can the average taxpayer in Florida.
and local tax deduction would still affect state and local
deduction claims through changes in the percentage of
The benefits provided by the state and local tax deduction
taxpayers who itemize deductions.
are dependent on a filer’s taxable income level. Since the
federal income tax rate regime is progressive (where the
The deductions for state and local taxes paid could also be
rate of tax increases with income), a tax deduction, in
modified to reduce the revenue loss associated with the
contrast to a tax credit, favors taxpayers in higher income
provision. One option would be to limit the deduction such
tax brackets because the value of benefits is directly
that only state and local taxes in excess of 2% of adjusted
proportional to a taxpayer’s marginal income tax rate.
gross income (AGI) could be deducted. The Congressional
Budget Office included this change in its most recent
Table 2. State and Local Tax Deductions Claimed
Options for Reducing the Deficit report, released in
Across Adjusted Gross Income Levels, Tax Year 2015
December 2016. JCT estimated that if implemented, such a
Share of Filers
Average
change would increase federal revenues by $955 billion
Claiming State
Amount
from FY2017 through FY2026. Other reform proposals
Adjusted Gross
and Local
Deducted per
have replaced the current deduction for state and local taxes
paid with a tax credit imposed at a “fixed” rate (
Income
Deductions
Claim
or a rate
that would not depend on a taxpayer’s marginal tax rate).
$1-$19,999
4.8%
$936
Policy Issues
$20k-$49,999
16.7%
$1,522
State and Local Government Effects
$50k-$99,999
44.1%
$3,194
The federal deduction for state and local taxes transfers a
$100k-$199,999
75.7%
$6,442
portion of the cost of state and local government services
$200k-$499,999
93.7%
$15,111
from the taxpayers claiming the deduction to all federal
taxpayers. An economic rationale for this transfer is that
$500k-$999,999
92.9%
$41,082
state and local government services may be underprovided
$1 mil ion+
91.2%
$247,776
if they provide benefits to non-taxpayers, also known as
“spillover effects,” even if the total economic benefits of
All filers
26.3%
$8,262
such services exceed their costs. Economic theory suggests
Source: Internal Revenue Service, Statistics of Income Data, Tax Year
that lowering the total cost of state and local services
2015, Tables 1.1 and 2.1.
(which may include infrastructure development, state and
local parks, and other common resources) encourages their
provision at levels closer to the economic optimum.
Table 2 shows deduction claim rates and average deduction
amounts for taxpayers across levels of AGI in tax year
Critics of the deduction assert that the federal deduction for
2015. Both the share of filers claiming deductions and the
state and local taxes paid encourages inefficient state and
average amount claimed increases with income, with a
particularly large rise in benefits at the top of the income
local spending. Under current law the subsidy is provided
for all state and local government activities, including
distribution. Of the total amount of deductions claimed,
84% went to individuals with AGIs greater than $100,000.
services with no spillover benefits. Reducing or eliminating
the deduction for state and local taxes would therefore
increase the after-tax cost of services to state and local
Since current law restricts claims of the state and local tax
taxpayers, which would likely lower taxpayer demand for
deduction to taxpayers with itemized deductions, disparities
those services.
in federal itemization rates also lead to relative differences
in the value of the state and local tax deduction across
Distributional Issues
jurisdictions. IRS data from 2015 indicate that while 30%
of taxpayers itemized their deductions nationwide,
The federal deduction for state and local taxes paid
represents a significant transfer of the combined federal,
statewide rates ranged from a low of 17% in West Virginia
state, and local tax burden. The benefits of the transfer to
to a high of 46% in Maryland. As 95.8% of taxpayers who
itemized their deductions claimed one or more deductions
households and jurisdictions may vary with (1) taxes levied
in states and localities, (2) taxpayer income levels, and (3)
for state and local taxes, relatively more taxpayers in
federal individual income tax itemization rates.
Maryland likely benefitted from the deduction than did
taxpayers in West Virginia. Differences in local tax rates
The value of the state and local tax deduction varies with
may produce further variation in state and local deduction’s
value across households.
the amount of taxes levied across jurisdictions. Taxpayers
who pay relatively high state and local taxes receive more
benefits from the federal subsidy than taxpayers with a
Grant A. Driessen, Analyst in Public Finance
lower state and local tax burden. For example, 2015 U.S.
IF10721
Census Bureau data indicate that potentially deductible
state and local taxes comprised approximately 6.3% of total
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Key Issues in Tax Reform: the Deduction for State and Local Taxes

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