Recently I wrote in these pages explaining why elimination of the state tax deduction, which seems to have wide support among conservatives, is neither a good, just, nor conservative idea. My argument rested primarily on the bedrock premise that it is fundamentally unjust for a citizen to be taxed by the federal government on income already taxed away by that citizen’s state government.
This fundamental principle about the relationship between the citizen and his state and federal governments, however, seems to ring hollow to many today who are more concerned about other considerations which I believe are, at least in part, based on an incomplete understanding of the state tax deduction and of its purpose.
In my previous article, I referred to a piece by Kevin Williamson in National Review in which he took profound pleasure in advocating for a tax change that he believes would represent a big tax increase on liberals, who, he seems to suggest (probably incorrectly), make up the bulk of itemizing taxpayers in high-tax “blue” states. Beyond this primal desire to stick it to liberals, Williamson makes the point that the federal government should be “neutral” in regards to how states raise their income and so giving a tax deduction for state income taxes is unfair to states that choose property taxes or sales taxes as their primary source of revenue. I did not address this point since it is flat-out factually incorrect. I have discovered, however, that this misconception seems to be widely held.
The fact is, the current state tax deduction does maintain the neutrality for which Williamson, and others, advocate. Look at Schedule A of Form 1040. The state tax deduction is not exclusive to state income tax. It just happens that for most taxpayers, state income tax is the largest portion of the deduction. Property taxes — on both real estate and personal property — are also included. Federal taxpayers also have the option of deducting either their state income tax or their sales tax. So if you live in a state like Washington, which has no income tax but a high sales tax, you can still take a deduction. As the law stands, the federal government is largely neutral on how it treats sources of state revenue — all major state taxes are currently deductible to taxpayers. The changes being discussed in Congress would simply change the “neutrality” to having the federal government taxing everything you have already paid to your state or local governments (or perhaps retaining a deduction only for property taxes — which makes no logical sense). Is that really the desired outcome, even if residents of high-tax, mostly “blue” states get hurt somewhat more by this tax increase?
But perhaps what really has the most appeal to many for getting rid of the state tax deduction is not a misunderstanding about its supposed discrimination, but the idea that it is a “subsidy” from the federal government (or from taxpayers in lower-tax states) to profligate high-tax states.
The idea that the state tax deduction is bad because it allows, and indeed encourages, state governments to have higher taxes than they would otherwise, lacks much credibility. As I pointed out in my previous article, nobody (or almost nobody) actually tries to make the calculation as to how much in federal taxes they save (before the fact) from this deduction. Indeed, with such complications as the alternative minimum tax, it is essentially impossible to do so until after filing of your federal return. So if individuals cannot, and for the most part, don’t even think to try to quantify the value of this deduction, it is highly unlikely that this deduction plays any meaningful role in individuals, or state governments, calculating what level of state taxation is tolerable. And I think we can all have a fair degree of certainty that if the state tax deduction were to be eliminated that state legislators in high-tax states (or lower-tax ones, for that matter) will not go to the drawing board and decide that they need to reduce their state’s taxes by some small percentage to compensate. (Remember the “truth to power” spoken by mean old Mitt Romney that many, if not a majority of voters, don’t pay much or any income tax.)
We are citizens of both our nation and our particular state. Our state and national governments both have roles to play for which they collect taxes (even if those roles are more than we think they should be). It has been a long-understood requirement of federalism that state governments and the federal government should not impinge on the rights of each other to collect revenue. Doing so would be a dangerous assault on the sovereignty of the offended party. That is why holders of state bonds do not pay federal tax on the interest payments they receive from the issuing state. Likewise, interest on U.S. Treasury securities is not taxed by state governments.
Since the founding there has been a fear that the federal government’s revenue needs would crowd out those of the states. To insure that that did not occur, and to prevent double taxation on individuals, it has been long practice that the federal government’s income tax would exempt income taxed away by the states. Conservatives have rightly complained about dangerous and inefficient interference by the federal government in realms that should be handled by state or local governments. Allowing the federal government to tax income already taxed away by the states in essence constitutes a federal tax on state revenues, elevating the relative power of the federal government and undermining an important protection to state sovereignty. This construct stands conservatism on its head.
It is a very dangerous thing to tell the federal government that it not only has a right to, but that it should tax income of individuals already taxed away by the state. Taxing someone on income he has already paid out in taxes is tyranny. Arguing that this is not important if, otherwise, residents of some high-tax “blue” states get a modestly greater federal tax deduction is a gross misplacement of priorities.