Deductions that Reward the Worst Managed States

Deductions that Reward the Worst Managed States


Why not do away with the deduction for state and local taxes? This loophole cost the country $46.5 billion in lost revenue in fiscal 2011, and essentially rewards the fiscal mismanagement of high-tax states. Asked about the proposal by the National Commission on Fiscal Responsibility and Reform to junk the deduction while retaining others, Senator Alan Simpson responded in an email, “We decided it was worth adding in a 12 percent charitable credit to help “the little guy” and a 12 percent mortgage credit on first homes up to $500,000 to protect the housing market -- but we didn't see a reason to spend $100 billion a year to subsidize high tax states…”   Doesn’t that make sense?

RELATED:  Tax Exodus: 5 States That Residents Are Fleeing

For 2012, the Joint Committee on Taxation estimates that 42.5 million returns will itemize deductions for $291.5 billion of state and local income taxes; the hit to revenues, assuming an 18 percent average rate on those filers, will be about $52 billion. In 2020, the CBO forecasts that the deduction will cost $110 billion. That’s money left on the table.

But don’t expect bipartisan enthusiasm for closing this loophole. According to the Tax Foundation, the states with the highest local tax burden as of 2010 (the latest available) were, in order, New York, New Jersey, Connecticut, California and Wisconsin – all sky-blue. The lowest were Alaska, South Dakota, Tennessee, Louisiana and Wyoming – all solid red states. Is it surprising that resistance to cutting out this tax preference comes mainly from Democrats?

Alaskans, who pay per capita the lowest state and local taxes in the nation, must wonder why New Yorkers, who pay the highest, should get help from Uncle Sam. Alaska residents, according to the Tax Foundation, paid in 2010 total state and local taxes of $3,214, or a rate of 7 percent of income. Alaska has no state income tax. The poor chumps in New York, whose high earners face a state marginal take of nearly 9 percent, handed over state and local taxes of $6,375 on average, a rate of 12.8 percent. But, the pain to Empire State residents is dulled by Uncle Sam; 32 percent of New Yorkers filing a federal return were able to lower their payments by deducting state and local taxes. 

Is that fair? High local taxes are not accidental. (Though, of course, some states benefit from having valuable resources such as oil, which are indeed an accident of nature.) Presumably state officials have enacted policies such as accepting unsustainable public union demands or imposing excessive welfare mandates that have required higher taxes. 

These are not hypothetical issues. The investment analysis site 24/7 Wall Street annually ranks the best and worst-managed states, based on criteria such as debt per capita, budget deficits, and local unemployment levels. By their calculations, California, which has recently overtaken Hawaii as the state with the highest marginal tax rate (13.3 percent), is also the country’s worst-managed state. Of the other highest-tax states listed earlier, all fall solidly in the nation’s bottom half but for Wisconsin, which is near the middle.

Don’t expect blue states to go quietly. In an October speech to the National Press Club, New York’s Senator Chuck Schumer argued (gasp) in favor of entitlement and tax reform, but pointedly insisted on the virtues of certain tax deductions – including those for state and local taxes, which he described as “too essential to middle class households.”  (Of course, Mr. Schumer also once proposed giving hunters tax deductions for contributions of killed deer to the needy, so he is not exactly a tax reform zealot.)

More recently, On CNN's "State of the Union with Candy Crowley," Sen. Dick Durbin from fiscally wounded Illinois (ranked the 48th worst-run state) touted tax reform but was careful to take “some of those things are near and dear to us …. (such as) deductions for state and local taxes” off the table. 
Those defending the deduction should explain why states that have worked to lure residents and businesses through attractive tax and regulatory regimes should bail out those that have done the opposite.  One scorecard comes from Chief Executive Magazine’s annual rankings of the best and worst states in which to do business. Some 650 business leaders picked Texas and Florida in 2012 as the most appealing states in which to operate; they likewise designated New York and California as dead worst.

As the magazine pointed out, the consistent poor rankings of California and New York might account for the net migration of more than 1.5 million people from each of those blue states between 2001 and 2009; Texas and Florida, in contrast, attracted the highest number of folks to their states during that period.

Badly run states should not be bailed out by others. Moreover, with most liberal politicians keen to raise taxes on high earners, defending the deduction looks downright hypocritical. Senator Simpson added, “As we looked into it, we found that more than four-fifths of the benefits of the State & Local deduction goes to households making over $100,000 a year. We thought it would be better to lower tax rates on all families and small businesses instead of subsidizing higher earners from States that try to raise taxes and make Uncle Sam foot part of the bill.” The voice of reason.