Eliminating the State and Local Tax Deduction Is a Terrible Idea

The tax “reform” currently being discussed in Washington is mostly a political exercise for politicians who can use the process to extract more campaign contributions from supporters, and punish non-supporters. The actual tax burden imposed on Americans overall will change little. 

The proposed elimination of the deduction for state and local taxes (SALT) is an excellent illustration of how the tax reform is really about playing political games. Forever in pursuit of “revenue neutral” tax reform, the GOP is simply turning to the elimination of the SALT deduction so it can raise federal revenues, and this allows for a tax cut for some other well-heeled special interest group. Using bizarre “logic,” supporters of the deduction’s elimination claim that an increase in the federal tax burden will somehow lower state and local taxes — some day. Why? They imagine that if they raise federal taxes for people in states with high taxes (i.e., California, New York) then the majority of voters in those states will then be clamoring for a cut in state and local taxes. The GOP also relies on the tired claim that that a tax deduction (e.g., the home mortgage interest deduction) “subsidizes” those who claim the exemption. But only in the Orwellian world of Washington doublespeak is a tax break a “subsidy.”  Moreover, given that states like California and New York are among the least reliant on federal funds, claiming that taxpayers there are “subsidized” by the rest of the country is an odd claim indeed.

There are several problems with this approach. 

First of all, the SALT  deduction — like all federal tax increases —  will drive ever more tax revenues to the federal government, putting more power, both in relative terms and absolute terms, in the hands of the federal government. This is one reason federal tax increases are even worse than state and local tax increases. They skew political power in the US ever more toward the federal government. By increasing the federal government’s share of all tax revenues collected, the federal government will also then be in a better position to manipulate state governments and state policymakers with federal grants. The federal government does this today by using federal highway funds. As the old saying goes, “he who pays the piper calls the tune.” 

An additional problem is that the elimination of the deduction is specifically aimed at increasing federal power at the expense of state and local power. There is no doubt that some conservatives and libertarians will cheer this. For many of them, the federal government and the county government are pretty much the same thing. In their minds, a Congress of out-of-touch millionaires 2,000 miles away is more or less the same thing as — or maybe even preferable to — a cash-strapped local government headed by middle-income part-time legislators.

This naive attitude is totally understandable for those who have never witnessed the very real differences between Washington politics and the politics of the local city council. But, there is a reason that subsidiarityand decentralization in politics have long been foundational elements of libertarian ideologies. Decentralization weakens political institutions, increases options for taxpayers, and contributes to a more vibrant private sector. 

The GOP’s efforts at eliminating the state and local tax deduction works in the opposite direction. The reform’s likely effect will be to further federalize the tax burden while making states more reliant on federal programs and federal grants. 

Americans Pay Most of their Taxes to the Federal Government 

At the core of the GOP’s drive to eliminate the SALT deduction is the assumption that state and local taxes are “too high” while federal taxes are apparently either just right, or even too low.  

But, it’s hard to see how anyone could come to the conclusion that the federal tax burden is the more harmless piece of the puzzle. The federal government already — by far — receives the largest share of the tax revenue pie.1

If we look at how much Americans pay to each level of government, we find that the federal government receives approximately two-thirds of all tax revenue, while only one third goes to state and local governments — combined. 

In 2016, the federal government collected more than $3.4 trillion dollars in revenue via income taxes, customs duties, fees, and revenues from federally-owned lands. 

State governments, on the other hand, collected only $1.1 trillion in revenues. Local governments pulled in even less, with under $800 billion in revenues.

What the GOP is now telling us is that the federal government’s huge share of the pie is too small, and federal revenues ought to be increased further via elimination of the deduction. This, we’re then told, will lead to declines in state and local taxes. 

The GOP doesn’t mention, naturally, that state and local governments are already falling in their share of overall tax collections. 

During the current economic expansion, the share of local tax collections — as a percentage of all tax collections — dropped from 17 percent to 15 percent. State tax collections meanwhile dropped from 22 percent to 20 percent. The federal government’s share of the pie, however, increased from 60 percent to 64 percent. 

The federal government now controls nearly two-thirds of all revenues paid into governments in the United States, and if current trends continue, we may soon see the feds in control of 70 percent, or maybe even three-fourths of all tax revenue. 

If this is the GOP’s plan, this is a rather odd position to take for a political coalition that claims to be in favor of “local control” and decentralization and federalism. In reality, the outcome of this war on the SALT deduction is to make the American political system even more dominated by federal power. 

Federal Revenues vs. State Revenues 

Even in high-tax states, the federal government plays a disproportionately large role in tax collection.2 

If we compare state tax collections to IRS collections in each state, we find that taxpayers pay much more to the federal government than they pay to the state government. 

In California, for example, the federal government collects $405 billion from California taxpayers. The state government, meanwhile, collects $155 billion. Federal revenues in California are more than two-and-a-half times as large as state-level revenues. 

In many states, of course, the results are even more lopsided. 

In Minnesota, for example, federal revenues are more than four times the size of state revenues. In Colorado, federal revenues are more than three times the size of state revenues. 

We don’t have data on specific local revenues here, but given that local revenues make up only 15 percent of tax collections nationwide, its a safe bet that federal taxes are considerably larger than local revenues in most cases. 

And yet, to hear the GOP tell it, its state and local taxes that are imposing the real burden on Americans. Their solution? Pay more taxes to the federal government! 

Decentralize the Taxes 

None of this is to say that state and local taxes are a good thing. There is no shortage of waste, corruption, and cronyism at the state level — but compared to the federal government the dollar amounts are tiny in state-level boondoggles. 

Nevertheless, the diversity of tax regimes across states and localities has long been one of the good things about the relatively decentralized political system in the United States. 

As we’ve already been seeing, this reality has allowed countless productive Americans to vote with their feet and to move from high tax jurisdictions to low tax ones. This phenomenon thus imposes pressure on many jurisdiction to keep taxes low compared to other nearby jurisdictions. This is known as “tax competition” and it results only when states and localities have considerable autonomy over their tax rates.3 

Unfortunately, tax competition is restrained by the fact that tax revenues in the United States are primarily a federal matter. Taxpayers thus have far less power to change their tax fortunes by moving across state lines that would be the case in a truly decentralized system. 

The downside to local autonomy, of course, is that some states and localities will have especially high taxes. The solution to this, of course, is to avoid investing in those areas until tax competition is sufficient to force more restraint on tax rates. 

Raising federal revenues via eliminating the SALT deduction — as the GOP seeks to do — is hardly any sort of solution at all. Indeed, Congress should be moving in the opposite direction. Instead of eliminating the deduction, Congress should substitute a tax credit instead. Every dollar that state and local taxes increase would lead to an equal drop in federal taxes. Then, we might start to see some real diversity in tax burdens across the United States. 

In reality, we’re seeing quite the opposite. Our current situation is made worse as federal taxes make up a larger and larger share of the overall American tax burden. This leads to greater homogenization of tax rates across the United States, which makes it even harder to escape from especially bad tax policy. If the tax burden is ever “equalized” across all states, then taxation will all simply be equally bad nationwide, and moving across state lines will bring no relief.