Tax Analysts Blog

How To Limit the Deduction for State and Local Taxes

Posted on Nov 30, 2012

In October 1985 the Ways and Means committee was in turmoil. Chairman Rostenkowski was desperately trying to get votes to pass his version of President Reagan's plan for tax reform. To pay for lower rates the plan from the White House included complete elimination of the state and local tax deduction. As a compromise that he hoped would appease lawmakers from high-tax states, Rosty's version called for only a partial elimination of the deduction. What the Chairman found out was that lawmakers from all states hated his idea. Rather than face an embarrassing defeat, the Chairman bent to the will of the members and kept the deduction entirely intact. (Birnbaum and Murray, Showdown at Gucci Gulch, pp. 128-137.)

This cautionary tale may not be enough to dent some politicians' current enthusiasm for getting rid of tax breaks, so I would like to offer here a new proposal for limiting the deduction that I believe would be better policy and better politics than proposals offered in the past.

First, a little quick background. On the politics: the deduction for state and local taxes is most beneficial to high-income taxpayers in high-tax Democratic-leaning states like California, New York, New Jersey, and Maryland (unless these taxpayers are already paying alternative minimum tax, but that's another story). On policy: the theory behind limiting the deduction is that state and local taxes are payments for government services similar to payments to business that provide services. In other words, government services are just another form of personal consumption--like getting a haircut or eating a pizza--and therefore should not be treated as a deductible expense.

In its 2011 report on deficit reduction options the Congressional Budget Office suggests capping the deduction for state and local taxes to 2 percent of adjusted gross income (Revenue Option 5, p. 148). My idea is to turn the CBO proposal on its head: turn the ceiling into a floor, that is, only allow deductions for state and local taxes above 2 percent of AGI (or some other percentage of income).

Why structure the limit this way?

On politics: as noted, a simple across-the-board limit on deductions already disproportionately hits high-tax states. The CBO proposal practically targets these states and looks like nothing more than a thinly-disguised partisan attack on blue states. My alternative would spread the burden much more evenly across states.

On policy: although there is some degree of truth to the idea that government provided services in certain circumstance are like private consumption, it is also true that governments' provide many services that are akin to those performed by charitable organizations. Social services, libraries, support for the arts, and--especially--education are a few that come to mind. So I do not think it is too much of a stretch to argue that certain basic services, like police and fire protection, are consumption (that should not be deductible) while those beyond the provision of basic services are activities like those provided by charities (and therefore deserving of a deduction).

Read Comments (1)

Ray in BowieNov 29, 2012

Oh, Magoo! You've done it again!

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