In the coming debate on tax simplification and reform, there will be emotional and hard-fought battles over the deductions and exemptions for charitable contributions, home interest, employer-financed fringe benefits and many other provisions of vital interest to particular industries, interests and sections of the country.
But there is one other prospective fight that has a different dimension to it, because it involves a debate about the constitutional basis of this republic, and particularly the relationship of the state and local governments to the nation.
The issue is the continued deductibility of most state and local taxes on federal income-tax returns. Almost $30 billion in added revenues would flow into the Treasury if the deduction for state- local taxes were endd, according to a recent study by the Advisory Commission on Intergovernmental Relations.
This makes it one of the genuine big- ticket items in the tax simplification debate. But the governmental issue is at least as large as the fiscal issue.
As Sen. Daniel P. Moynihan (D- N.Y.) has pointed out, deductibility of state-local taxes was built into the federal income-tax law almost 75 years ago in explicit recognition of the principle of federalism. Even at the minimal level of the original income tax, the framers of the legislation were prepared to acknowledge that Washington did not have a preemptive claim on the resources needed to sustain government.
By making state-local taxes deductible on the federal returns, Congress was deliberately giving its partners in the state capitals and city halls the first crack at available tax revenues.
For those like this reporter who have championed the role of state and local government and welcomed the growing capacity they have shown in recent years to meet their responsibilities, the argument raised by Moynihan and others in defense of continued deductibility is a powerful one.
But it is not the only one, and the ACIR report offers a valuable guide to those seeking to sort out this important issue. It dramatizes the importance of deductibility as a source of funds for the states. In fiscal 1983, for example, tax deductibility represented about one-fifth of all federal aid -- direct and indirect -- to state and local governments. If you add the exemption on interest paid on state and local bonds, deductibility reaches half the level of direct grants-in-aid.
In essence, deductibility reduces the cost to the taxpayer of state and local taxing and spending. ACIR estimates that if it were abolished, state-local spending would fall about 7 percent a year; others think the effect might be much greater. But proponents of federal tax reform point out that the rate reductions promised by their plans would ease that effect and leave more room for state-local taxes.
Still, for those who welcome activist state-local governments, there is little question that curbing deductibility would have something of a chilling effect.
But the impact would not be felt at all evenly, so there is an equity factor to be considered as well. "Upper-income taxpayers residing in high- spending states with relatively progressive tax structures gain the most from deductibility under the present tax code," the ACIR study prepared by Daphne A. Kenyon points out.
New York is one of those states, along with California, Delaware, Maryland, Massachusetts and Washington, D.C. It is not a coincidence that Moynihan and New York Gov. Mario Cuomo have been so vocal on this issue.
Because the wealthy are much more likely to itemize, and the deduction is worth more in their higher federal tax bracket, deductibility of state-local axes gives them a double benefit. It means they get a bargain on the state-local services they purchase through their taxes and it means they are benefited by the federal tax break as well.
These equity questions cannot be dismissed, but neither can the federalism issues that are embedded in this controversy. Resolving the deductibility fight may be as tough as anything in the tax- simplification debate. And it will shape the future of government in this country on all levels.