Friday, February 22, 2008

State and Local Tax Deductibility Re-Revisited

by Tom Bozzo

Apropos of (almost) nothing, Felix Salmon expresses some hope that President Obama will end the federal income tax deduction for state and local taxes, suggesting that as a policy matter, the deduction "really makes no sense" and making a progressive's case that — like itemized deductions generally — the benefits largely accrue to the well-to-do.

Now, the CBO study that Felix cites was commissioned by the "ranking member of the Senate budget committee," a.k.a. Sen. Judd Gregg, Republican of New Hampshire. Could he be a closet progressive tax-raiser? In late '04, we found Jonathan Weisman of the Washington Post reading the 2003 Economic Report of the President. It turns out that there's a political agenda to this tax policy change:
Then comes the Washington Post's Jonathan Weisman with the answer:

In crafting a broad [tax reform] agenda for his second term, Bush is trying to adhere strictly to economic theory...

In a speech... at the American Enterprise Institute, N. Gregory Mankiw, chairman of the White House Council of Economic Advisers, spoke repeatedly of "standard economic theory," "textbook economic theory" and "scholarly literature in economics" to bolster his arguments.

Well, that makes me feel a lot better. I won't be screwed as a payoff to even fatter cats, but simply as a matter of inexorable economic logic. Notes Weisman:

In the February 2003 Economic Report of the President, the White House held that the deductibility of state and local taxes -- especially property taxes -- "lowers the price of local public services" and unfairly favors local government services over privately provided services. [emphasis added and changed from the 2004 post]

And here's what I had to say about that:
It's true enough that the tax deduction for property taxes insulates me from the full brunt of my $7,690 property tax bill [those were the days!] in an amount determined by my marginal federal income tax rate. So I'll demand more services from the city than I would in the absence of deductibility because part of my would-be cost is effectively pushed off onto the upper-income Federal taxpayer. (Which is to say, I'm subsidizing my own consumption of local government services. I shall write myself an indignant letter.)

...[T]he ERP logic begs the question of whether it makes any sense to raise the price of local services. An almost equally well-known result of "standard economic theory" is that private interests will underprovide collective goods (law enforcement, for instance). For public services that are not quite pure collective goods, the question is whether we are actually over-consuming anything such that we should get a price signal to use less. For instance, given that roughly half of the Madison tax bill goes to the school district, is there really a problem that Madison's schoolchildren are getting "too much" primary and secondary education? Of course, since the quality and quantity of public services helps support Madison's high property values, there's some tradeoff between the size of our tax bills and our property wealth.

For another, the idea that it's "unfair" to support local provision of public services over private services -- which private firms may or may not deign to provide -- is a matter of religion and not economic theory... Does living on a 5,500-sq. ft. urban lot, without so much as an indoor parking space... and thus relying on the nearby public parks to burn off excess toddler energy, create a material unfair burden on Rainbow Play Systems, compared to the alternative of needing to provide my own "park" on a one-acre lot out in [exurban] Cardinal Point Estates? If your answer leans to the affirmative, please account for the cost of the non-private provision of the roads between the 'burbs and the rest of the world and re-answer.

The CBO raises a related issue of the extent to which there are regional or national spillovers for local expenditures:
  • Whether the deduction is an efficient use of federal resources depends on the nature of the benefits from any services at the state and local level that it subsidizes.
    • To the extent that state and local taxes are payments by residents of those jurisdictions for services that they themselves receive from their state and local governments, the rationale for a federal subsidy is weak.
    • In contrast, if state and local taxes pay for services that have spillover benefits that are regional or national in nature, then a federal subsidy may be desirable to ensure that an adequate volume of such services is produced.
State and local taxes mostly pay for a few big things: public K-12 and higher education, transportation, health and welfare services, public safety, and community development. While the CBO director doesn't make the judgment, it should be obvious enough that the major expenditures have material "spillover benefits" and so the standard public goods argument for subsidy applies.

It's also perhaps worth remembering that, while its effect isn't included in the CBO calculations, lower-income taxpayers get an implicit state-and-local tax deduction via the federal standard deduction. I don't mean to say pity the poor upper-middle class, though. Rather, a proper "reform" would ideally address the entirety of the issue, which the deduction for itemizers isn't. To give Felix his due, I don't dispute the possibility that the tax system could be improved by applying generally lower rates to broader income. But a truly equitable, and socially efficient, solution would not only have to address the tax policy side of the issue, but also the local spending side — via, for instance, direct federal subsidies to replace the implicit subsidies from the current-law income tax. And good luck getting cloture on that.

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Doesn't the deduction for local property taxes have the salutary effect of adding some moderate progressivity to the tax code within the income range of the middle- and upper-middle class?

Along with the mortgage deduction, it's responsible for lowering my tax rate from a marginal 28%, to something more like 10%. Because deductable housing costs rise sublinearly versus income when you get into the echelons of the super-rich, and because of the AMT, it's effectively a subsidy from the very wealthy to the only moderately wealthy.

While the deduction is not the best way to do this, and is clearly inferior to simply making the tax brackets more progressive to begin with, it's better than nothing, especially when considering that much of the federal tax burden is actively regressive to begin with.
Ben, I see deductions and other forms of tax-preferenced income as working against progressivity, other things equal. (Think of them as giving people who earn and/or spend more money in preferred ways a bigger zero bracket than someone who doesn't.) The AMT interaction can lead to very high marginal rates for some taxpayers as AMT kicks in, but that isn't necessarily "progressivity," since someone richer would see the marginal rate *decline* to the AMT rate or the regular income tax rate as applicable.

That said, I agree that the rich and super-rich have a hard time consuming housing in proportion to their incomes -- not, at least in extreme cases, always for want of trying -- so yeah, I think there probably is a bit of downward redistribution within the well-to-do. And, depending on what would happen to local government spending and taxes, you definitely can't assume it'll improve things to get rid of the deduction.
I'll argue that deductions, etc. don't work against progressivity as much as they work against transparency and fairness in the tax code. In general case, a bigger virtual zero bracket makes things marginally more progressive as long as the expenses being zeroed are widely distributed.

The progressivity is a feature, not a bug. The bug is the way preferences in the tax system attempt to modify behavior, particularly in cases where the behavior can't reasonably be modified ("Ford to City: buy more houses").

This just ends up preferencing more-or-less arbitrary groups of people for arbitrary reasons. In this case, it benefits homeowners in the high-tax, high-service states of the upper Midwest versus renters in the big coastal cities.

But in the end, I guess I come down on the side that says the features outweigh the bugs (and in any event the bugs work in my favor). While I'd probably support more comprehensive reform, simply eliminating the deduction strikes me as a bad idea without much upside, and not particularly liberal.
You like the implicit subsidies? So do I, frankly, and as a New Yorker I get more of them than just about anybody else in the country. But if you like implicit subsidies from the federal government to local government, then you should want those implicit subsidies to be reasonably fairly distributed, rather than being concentrated overwhelmingly in NY and a few other states. Or do the poorer states not deserve those subsidies?
Felix, sure I'd like to see the subsidies more equally distributed in principle -- but it would take a more comprehensive (and even more contentious) reform of federal, state, and local tax systems and spending to do that.
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