Gladriel Shobe is a tax professor at Brigham Young University Law School.
The House Republican tax plan proposes repealing much of the state and local tax deduction, allowing individuals to deduct up to $10,000 of local property taxes but eliminating the rest of the deduction. This gets sound tax policy precisely backward. Smart tax reform would allow taxpayers to deduct what they pay to states — and would end the deduction for local taxes.
The treatment of the state and local tax deduction is one of the central points of contention in the tax-reform debate. President Trump and most Republicans want to repeal or modify the deduction, which could raise more than $1 trillion over the next decade. Republican and Democratic members of Congress from high-tax states are protesting any repeal because it would disproportionately harm their constituents.
But the reality of the distribution of benefits and costs of the state and local tax deduction is more complicated than high-tax (mostly blue) states vs. low-tax (mostly red) states. As the House Republican tax plan implicitly acknowledges, the state and local tax deduction in fact combines two very different deductions: a state deduction for state income taxes (or, much more infrequently, sales taxes) and a local deduction for property taxes. When looked at this way, the issue is both a high-tax state vs. low-tax state issue and a rich-locality vs. poor-locality issue, with the federal government providing a disproportionate subsidy to high-tax states and high-tax localities.
Understanding that the state and local deduction is in fact two deductions is important because states and localities fund very different things. Local taxes typically benefit those within relatively homogeneous localities in a way that is similar to a purchase of private goods. When residents pay local taxes, those taxes fund local schools, parks and recreation, police and fire agencies, and so on, that provide a relatively direct benefit to those paying the taxes. Wealthy individuals benefit from their local taxes in much the same way they benefit from purchasing a membership to a private club. No one seriously argues that a membership to a private club should be deductible, yet in effect that is what the deduction for local taxes allows.
State taxes, on the other hand, are less like private purchases because states spend a significantly higher percentage of their revenue on redistributive programs, such as state welfare programs, funding for poor school districts and health care for low-income residents. When wealthy individuals, who gain the most benefit from deductibility because they pay higher marginal tax rates, pay state taxes, that cost looks more like a charitable contribution than a membership in a private club, and so a deduction is more justified.
Therefore, smart tax policy would allow taxpayers to deduct the cost of state income taxes while eliminating the deduction for local property taxes. As it happens, because local taxes account for approximately half the overall deduction, this change would raise approximately $500 billion over the next decade.
Instead, House Republicans propose doing just the opposite. By retaining deductibility for local property taxes, their approach would continue to disproportionately subsidize wealthy, country-club-like localities, albeit to a smaller degree for the wealthiest towns and cities because of the $10,000 cap. And by eliminating deductibility for state taxes, the tax plan would end the federal government's subsidy for state governments, which spend a significant percentage of their revenue on redistributive programs.
This may placate the powerful real estate lobby and taxpayers from wealthy localities, but it is bad tax policy. The types of goods and services provided by localities are not bad, but they are unlikely to need a federal subsidy, because taxpayers see a direct benefit from the local taxes they pay. By contrast, the federal government should want to incentivize the types of goods and services provided by states because they disproportionately benefit the less wealthy and are therefore likely to be undersupplied.
A smarter tax policy would be to repeal deductibility for local taxes altogether and retain deductibility for relatively redistributive state taxes. This could be structured to raise the same amount of revenue as the Republicans' current proposal but in a way that would provide a federal subsidy for things that are worthy of being subsidized.