In a
recent post in the Washington Post, Charles Lane argues that the least defensible deduction is the deduction State and Local Taxes. His rationale is that this is "
this one overwhelmingly benefits upper-income households in a handful of upper-income states, while rendering the entire nation’s finances less transparent." Later in the article, Charles Lane explains his real rationale for picking this as the least defensible deductions: "But because its impact is so heavily concentrated in blue states, the state and local deduction creates an asymmetry: Democrats have an extra reason to insist on raising rates, and Republicans have an extra incentive to demand loophole-cutting. Perhaps it’s just coincidence, but I have noticed that those most skeptical of the loophole-closing approach include Sen. Charles Schumer (D-N.Y.) and House Minority Leader Nancy Pelosi (D-Calif.)."
When I read his analysis I was struck by a number of issues that I thought I should clarify.
- Is it unfair to tax taxes already paid?
Here's Charles Lane on the subject: "Taxpayers have been allowed to deduct state and local income and property taxes since the federal income tax began in 1913. (Sales taxes have at times been deductible, too, but that’ s a relatively minor issue.) The theory is it’s unfair to make people pay twice for the public services they receive. That’s doubtful, though, since, despite some overlap, federal taxes support different services than state and local."
Hmm ... let's consider a thought experiment. Let's say state and local taxes were 60% and Federal taxes were also 60%. At this point, if the State and Local tax deductions were allowed, the effective tax rate would be 84%. Under Charles Lane's formula, you could not claim the deduction for State and Local taxes and so the effective rate of taxes would be 120%, i.e. more than aggregate gross income.
I am not sure that there is a positive test for a relatively normative issue like "fairness". However, if something is structurally unsound enough to result in absurd answers like taxes owed being higher than the gross income, it comes pretty close to QED.
This is why, as Charles Lane himself acknowledges, the deduction for State and Local taxes has been part of the code since 1913 when the Income tax was introduced.
- Isn't this mostly a deduction for rich people?
Well, yes. It is. However, that isn't unusual.
As you can see, while state and local taxes are somewhat skewed towards the higher income, it is by no means the most skewed - that honor goes to Capital Gains and Dividend Tax reduction.
- Are Blue states mostly takers and Red states mostly makers - i.e. isn't this a handout to taker Blue states?
In one sense this isn't wrong. After all, if Blue states have higher effective taxes, the deduction disproportionately benefits them.
In another sense this isn't right. Here's a view of net contribution to Federal government sourced from Wikipedia (i.e. how much the state contributes by way of taxes less the benefits they receive from the Federal Government):
Of the 24 states that voted for Romney, 19 had a net deficit, i.e. they contribute less to the Federal Government in taxes than they collect in Federal spending. By contrast, 14 of the 28 states and territories that voted for Obama had a net deficit. In fact, the aggregate for all the states which voted for Romney was a deficit of $64,911 million, whereas the aggregate for the states that voted for Obama was $206,848 surplus. Let me restate that, the red states contributed less in taxes than they collected from the Federal government, the Blue states by contrast contributed more in taxes than they collected.
This is important because the argument hinges on the conflation of blue states and high taxes with "moochers". Turns out that this conflation is probably not right.
Changing topics a bit, as an aside, the chart of the percentage of the deduction that goes to the rich shows that a lot of these deductions are actually designed to assist those with lower incomes. So, when someone is arguing the removal of deductions to "widen the tax base" they mean a middle to lower income tax hike. This raises an interesting question: just how egregious is the tax on the higher income to necessitate such base broadening?
Well, one way to think about this is to compare the effective tax rate for those at the higher income levels, i.e. with incomes over $100K, to those of other countries. It just so happens that the Economist has done just that recently:
Strangely, the US' effective tax rate for $100K+ income is among the low end of the spectrum of the selected countries and will likely remain so even if the proposed marginal tax rate hike goes into effect for those with $250K+ income.
