The Elimination of the Federal Tax Deductibility of State and Local Taxes: Possible Effects on State and Local Tax Structures

Through the use of intermediaries such as elected officials and hired advocates, people choose the level of resources that will be used for public goods and services, as well as the manner in which those resources will be used. They also decide how these goods and services will be financed. The extent to which governments utilize taxes on income, wealth, and consumption is guided by considerations of political factors, equity, administrative costs, revenue adequacy, and the effects of the tax system on allocative efficiency. Incentives that are embedded in the federal tax system may also influence state and local tax structures. Taxpayers who itemize can deduct state and local income and property taxes from income that is subject to the federal income tax. General sales taxes can be deducted in place of income taxes. In 2005, the President’s Advisory Panel on Federal Tax Reform recommended the elimination of the federal tax deductibility of all state and local taxes. If state and local tax structures are responsive to federal tax deductibility, then this policy change could affect the extent to which governments rely on the three major personal taxes: income, property, and sales. I attempted to estimate the nature of the effect by conducting a multivariate regression analysis on the cross-section of the fifty states. The results suggest that the elimination of federal tax deductibility would induce a shift in state and local tax structures from income to consumption taxation. Since it is possible that consumption taxation distorts economic behavior to a lesser degree than income taxation, this policy change may increase the efficiency of state and local tax systems. However, consumption taxation tends to place heavier tax burdens on low-income households while income taxation tends to place heavier tax burdens on wealthy households. This means that the elimination of federal tax deductibility may reduce the vertical equity of state and local tax systems. However, the federal income tax may become more progressive, since the wealthy derive the greatest benefit from the federal tax deductibility of state and local taxes