No, Mr. President, the Deduction for State Income Tax Is Not a Loophole

[Cross Posted from Inequality.org]

The one “loophole closing” Trump has proposed would actually reduce tax revenue — state tax revenue, that is.

The Trump-GOP tax plan, based heavily on tax cuts for corporations and the wealthy, would cost $2.4 trillion in lost federal revenue over 10 years, according to the nonpartisan Tax Policy Center. And the only “loophole” the plan closes to offset this enormous revenue loss is the deduction for state income tax paid by individuals.

Is that a loophole? Hardly. A loophole is a tax code provision that allows taxpayers and their advisers to game the system, typically through the generation of artificial deductions or credits that reduce tax. The deduction for state income tax doesn’t fit that description.

Your state income tax bill is a cost of producing income, just like the expenses a business pays to produce its income. And, unlike most business expenses, you have no control over your state income tax liability.

Above all else, the deduction for state income tax is fair. Compare, for example, a married Oregon couple who earn $136,000 and pay $11,000 in state income tax, leaving $125,000 after the involuntary state tax payment, with a Texas couple who earn $125,000 and pay no state income tax. Those two couples are in the same position, but unless the Oregon couple can deduct state income tax on their federal return, they likely will have a higher federal tax bill.

Trump and others try to justify the elimination of the deduction for state income tax on the basis that it is payment for the services state governments provide. But there are two flaws in that logic. First, there’s no proportionality between a person’s state tax bill and the services he receives. A family that receives twice as much as the average resident in services because they have a large number of children in public education or have a house fire put out by firefighters does not pay twice as much in state tax.

Second, states with alternative revenue sources provide the same services, but nobody seeks to tax residents of those states on the receipt of those services. For example, the services that residents of Texas receive effectively are non-cash distributions of the state’s oil and gas royalties, but no politician would dare suggest we tax Texans on the value of those distributions.

Even putting aside the blatant unfairness, eliminating the deduction for state income tax is poor federal tax policy because it indirectly puts pressure on state revenues. When no federal level deduction is allowed for state income tax payments, the real, after-tax cost of those payments increases. That means the cost of living in states that depend on income tax revenue increases relative to states with alternative revenue sources, which in turn places undue pressure on legislators in those states to reduce tax rates and to pay for those rate cuts by paring back spending on infrastructure development and education.

The worst effects of eliminating the state income tax deduction will be seen in states with major metropolitan areas that straddle borders between two or more states with different income tax rates. Consider, for example, the Portland metropolitan area, which includes residents of both Oregon and Washington. Oregon charges income tax, whereas Washington does not. If the deduction for state income tax is eliminated, Oregon legislators could face a “take it or leave it” Hobson’s choice: reduce tax rates on affluent Portland taxpayers and slash the state budget, or watch as wealthier residents move to Washington, which would result in a decline in Portland property values relative to those just on the other side of the state border.

In the end, a large portion of the federal revenue raised by the elimination of what Trump calls a loophole allowing for the deduction of state income tax may be matched by a reduction in state level revenue — including revenue that currently funds the Oregon budget.

Republicans have talked for years about the need to close tax loopholes. Rather than eliminating the state income tax deduction, they should go after the ones that have allowed the wealthy and big corporations to rig the rules in their favor.

5 Responses to No, Mr. President, the Deduction for State Income Tax Is Not a Loophole

  1. Sen. John Kavanagh

    Funny, California does not agree with you. Based upon an analysis done by the California Legislative Analysts’ Office, California is just barely a donor state:

    “In January 2017, the California Legislative Analyst’s Office said by several measures California is, indeed, a donor state, but just barely. It receives $0.99 in federal expenditures per dollar of taxes paid, which is below the national average return for states of $1.22 per dollar paid, according to its review of a 2015 New York Comptroller study.”

    So California only loses 1 cent on the dollar. Now I do agree that, as a group, high tax states generally pay more but it is their decision to tax high for extra benefits, be they infrastructure, social programs or free utilities for their residents. Why should Arizona subsidize them, especially he biggest one, California, which seems to be breaking even?

    • I’m not sure of your analysis. If State A has higher income taxes than State B in order to pay its teachers more than State B, it seems like there’s an offset. Yes, many, but not all, State A taxpayers will have larger itemized deductions than their State B counterparts, but State A teachers will have higher federal taxable income. Seems like it would be a wash, or close.

      But I wonder if you feel the same way about some charitable contributions. When folks contribute to their church, do you think the deduction for that contribution is a subsidy to them?

      And how would you treat the receipt of state government services paid for by, say, royalty income in Texas? Would that be considered income to Texas residents? By your logic, it seems like it should.

  2. What a silly argument. The state income tax liability is a direct subsidy of the rich and a direct subsidy of profligate states.

    Why don’t we let taxpayers deduct their food costs, their electric bills, their phone bills?

    [Note to readers: If Thucky were intellectually honest, he would go on to take the position that when a state like Texas or Alaska uses its mineral royalty income to provide services to its residents, they should pay federal tax on the value of those services.]

    Good try.

  3. Sen. John Kavanagh

    There is another side to the issue of fairness concerning these deductions.

    After all, Arizonans and residents of other low-tax states must subsidize the state and local taxes paid by residents of high tax states, such as New York, New Jersey and California, because of that deduction provision. That provision allows residents of high tax states to deduct up to 39.6%, if upper bracket, of their state and local income and property taxes from their federal tax bill. And because many high tax states provide residential water, sewer and trash pickups, we are paying up to 40% of those bills too!

    And how is paying your state and local property tax and income tax a “cost of doing producing income” like a business tax.?”

    Maybe elimination of the deduction is not practical but some cap should be imposed.

    • I was careful not to mention the deduction for property tax. That deduction is not justifiable. And, as it stands, it’s unfair. Renters pay the tax as well, because landlords pass it through, but renters are not allowed the deduction.

      As for your comment regarding a cap, there is one – the alternative minimum tax.

      But as for fairness, you’re cherry picking. If you look at the comparison of what states contribute to federal revenue to what they receive in transfer payments, it’s actually the higher tax states that come out on the short end.