How the tax code helps taxpayers in Big Government states pay less

By Jarrett Stepman | The Daily Signal

As Congress works on tax reform, it is worth noting how politicians and interest groups use the code for their benefit often at the expense of others.

Some of the worst abusers are the states.

One of the most overlooked issues with federal tax policy is how states exploit federal deductions to underwrite their spending and paper over higher tax rates.

Under current laws, taxpayers have the ability to deduct state and local income and property taxes from their income when filing their federal taxes.

So if a person making $250,000 a year pays $26,000 in state and local taxes and donates $14,000 to charity, he could deduct $40,000 from his salary. This person would pay taxes on only $210,000.

Of course, everyone wants to pay fewer taxes. But under these rules, the wealthy have a much better opportunity to do so than those who are lower on the income scale.

While lower taxes are generally a good thing, deductions just shift the tax burden instead of reducing taxes in total. And they add further complication to the code that must be worked around.

According to Heritage Foundation research, over 70 percent of taxpayers don’t receive benefits from this state and local tax deduction. Yet, over 90 percent of taxpayers making over $200,000 do.

Those who make more can better take advantage of this tax situation, but the greatest beneficiaries are the big, high-spending states. They still reap the financial reward of having higher taxes while the federal government picks up a portion of the tab—and that tab is an estimated $1.7 trillion over the next 10 years, according to The Heritage Foundation’s Center for Data Analysis.

In fact, just seven states receive 53 percent of the value of the state and local tax deduction: California, New York, New Jersey, Illinois, Massachusetts, Maryland, and Connecticut.

On average, taxpayers in those states who itemize deduct 7.6 percent of their income in state and local taxes, compared to 4.2 percent of income among other taxpayers who itemize in all other states.

So, to make this situation even more unfair, the citizens of low-tax states that have controlled their spending have to bear a higher burden for the shortfall in federal taxes.

Ending these types of deductions could make states more accountable and efficient.

Efforts to change this part of the tax code have been around for a while.

President Ronald Reagan tried to repeal these deductions in the 1980s. He said in a 1985 speech that taxes could generally be reduced if they were simplified and we removed the special provisions that “favor some at the expense of others.”

Reagan said, “I don’t believe that we can justify a system that forces taxpayers in low-tax states to subsidize the big-spending policies of a few high-tax states. That really is taxation without representation.”

While Reagan got his tax cuts, he wasn’t able to change this deduction.

But without getting rid of deductions, rates can’t decline by as much. A recent Heritage Foundation analysis estimated that the revenue gained by eliminating state and local deductions would be enough to reduce marginal tax rates by as much as 16 percent.