Tax Reform And The State/Local Income Tax Deduction

Despite their constant focus on "inequality," do you ever notice that you don't see Democrats talking much about income tax reform?  There's a simple reason for that.  All income tax reforms are a variation on the same theme, which is some combination of lower marginal rates and fewer "loopholes."   In the current tax regime the "loopholes" turn out mainly to benefit the rich constituencies of the Democratic Party.   Best to keep quiet about that. 

The broad definition of a "loophole" is a deduction you don't like.  If by "loophole" you mean something that's obviously abusive (as opposed to a legitimate disagreement over policy), they actually got rid of the most expensive and abusive of those over the course of the last 30 years, particularly what we used to call "abusive tax shelters."  Today, there are buried in the tax code plenty of special giveaways to one company or industry or another, but no one of them has big money associated with it.  If you're looking for big money, you have to look at the big money deductions.  And the big money deductions primarily go to the members of the top 1% who live in the big blue states and support the Democratic Party.

The big two here are the deduction for mortgage interest and the deduction for state and local taxes.   The mortgage interest deduction costs the Treasury some $70 billion per year, according to data from the Joint Committee on Taxation for 2013 cited here.  The state/local tax deduction (both income and property) costs the Treasury even more, $77 billion per year, per JCT data cited here.  The benefits of both are highly concentrated among the wealthiest taxpayers, but the benefits of the state/local tax deduction are further heavily concentrated in the high income tax states.  In other words, any mention of the state/local tax deduction is a mortal threat to California, New York, New Jersey, Connecticut and Illinois.

I think this is a rather obvious issue, yet it's amazing how little attention it gets.  Then again, our incumbent media do have an agenda.  Back in November 2012 I wrote a couple of articles on the subject, here and here, in the context of the presidential campaign.  Romney was talking at the time about tax reform, including elimination of deductions, although he never was specific about which deductions.  But you don't have to look far before you realize that the state/local tax deduction would be first on the chopping block.  Then, when the election was over, the issue died.

Now along comes Dave Camp, Chairman of the House Ways and Means Committee, with his own big new tax reform proposal.   There's lots to it, and I can't discuss everything.  But perhaps the single biggest item is total elimination of the state/local income tax deduction.

Now, living here in Manhattan and paying rather large state and local taxes myself, I do have a self-interest in this.  But I must admit that this is rather a perfect issue for the Republicans.  The concentration of the benefits of this deduction in a few big blue states and on a few of the highest income taxpayers in those states is really quite remarkable.  According to an August 2013 article from the Committee for a Responsible Federal Budget, citing CBO data, 30% of the benefits of this deduction go to the top 1% of taxpayers, and 49% to the top 5%.  Among states, California taxpayers gets 17.2% of the benefits  (with 11.9% of the population), New York gets 13.3% of the benefits (with 6.2% of the population), and, at the other end, Texas gets 4% of the benefits (8% of the population) and Florida gets 2.9% of the benefits (6% of the population).

So are Democrats engaged in protection of their very highest-earning taxpayers (and contributors) in the very bluest of states when they protect this deduction?  Absolutely.  Moreover, the deduction can fairly be viewed as a big wealth transfer from the likes of Texas and Florida to California and New York.  I can't see why it's not fair to point that out.

Meanwhile, the very valuable Mercatus Institute is out with a recent (January 14) study called "State Fiscal Condition: Ranking the 50 States."  It's a fairly complicated methodology that combines four different measures.  But when you get to the bottom line the funny thing is, the high tax big blue states all come out at the very bottom in "fiscal condition."  (45 - New York; 46 - California; 47 - Massachusetts; 48 - Illinois; 49 - Connecticut; 50 - New Jersey).  Wouldn't you think that with their far higher taxes (plus the big boost from the Feds hidden in the deductibility of those taxes at the federal level) they would have far better ability to pay the bills?  But it turns out that they just spend the money as fast and faster than they take it in, mostly on favored union constituencies.  In the current political environment in New York, the public employee unions own the place.  And that's not going to change without a big kick in the pants from outside.  Elimination of the state/local tax deduction anyone?