February 20, 2008
CBO released a report today on the deductibility of state and local taxes on federal income tax returns, which provides an indirect federal subsidy to the state and local governments that levy deductible taxes. The state and local tax deduction reduced federal revenues by an estimated $50 billion in fiscal year 2007.
CBO's report, which was prepared at the request of the Ranking Member of the Senate Budget Committee, examines the justifications for the state and local tax deduction, how its benefits are distributed among different groups of taxpayers, interactions between the deduction and the Alternative Minimum Tax (AMT), and options for modifying or eliminating the deduction.
The main points of the report include:
- 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.
- Some evidence suggests that state and local governments may respond to the taxes-paid deduction not by imposing higher taxes but by simply using deductible taxes in place of some nondeductible taxes.
- In 2004, slightly less than 35 percent of all taxpayers deducted state and local taxes they had paid, but whether a taxpayer claimed the deduction and the value of that deduction varies considerably according to income. Taxpayers with incomes below $75,000 in 2004 accounted for more than 80 percent of all taxpayers but less than 20 percent of the total tax benefit from the deduction; taxpayers with incomes above $1 million accounted for 0.2 percent of all taxpayers and 16 percent of the total tax benefit from the deduction.
- In 2004, potentially deductible taxes accounted for 17 percent of state revenue and about 40 percent of local government revenue (in both cases excluding revenue received from another government or from government-run entities like utilities).
- Over the next several years, scheduled changes to tax law and the interaction of the regular income tax and AMT will change the number of taxpayers who claim the deduction and the associated loss of federal revenues. The amount of that loss is projected to diminish through 2010, becausea growing number oftaxpayers will pay the AMT, which does not allow people to claim the deduction. The scheduled expiration after 2010 of tax provisions enacted in 2001 and 2003 will boost income tax rates for many taxpayers, raising the value of the taxes-paid deduction for those who claim it and increasing the associated revenue loss for the federal government.
- With assistance from the Joint Committee on Taxation in estimating budgetary effects, CBO analyzed many options for changing the deduction with and without changes to the AMT. For example, eliminating the deduction and indexing the AMT to inflation would, in combination, raise federal revenue by about $450 billion over the next decade. Replacing the deduction with a 15 percent credit while indexing the AMT to inflation would reduce revenue by $330 billion from 2008 to 2017. Other options are discussed and analyzed in the study.
The study was written by Kristy Piccinini of our Tax Analaysis Division. Kristy works in the areas of state and local taxation and tax-exempt bonds. She joined CBO in 2006 after receiving her Ph.D. in economics from the University of California Berkeley. Her dissertation examined how state tax legislation responds to changes in the budget balance.