Yesterday Frank Sammartino, CBO’s Assistant Director for Tax Analysis, testified before the Senate Finance Committee on federal support for state and local governments provided through the tax code and on some ways in which tax reform might affect that support.
The testimony focused on two particular aspects of current policy:
The federal government provides preferential tax treatment for bonds issued to finance activities of state and local governments. As a result, those governments are able to borrow more cheaply than they otherwise could. At the end of 2011, state and local governments owed roughly $3 trillion in the form of tax-preferred bonds. (See our analysis with the staff of the Joint Committee on Taxation (JCT) titled Subsidizing Infrastructure Investment with Tax-Preferred Bonds for more information.)
The most common type of tax-preferred bond is one in which interest income is exempt from federal taxes. Such tax-exempt bonds are a relatively inefficient mechanism for transferring funds: the federal government forgoes more in tax revenues than state and local governments receive. Estimates suggest that the difference is about $6 billion per year—or about one-fifth of the approximately $30 billion in federal revenues lost through that tax preference. That sum accrues to investors who pay high marginal tax rates.
Another type of tax preference for a state or local bond, which until recently has not been much used, is to offer a federal tax credit in lieu of some or all of the interest income from the bond. Unlike tax-exempt bonds, for tax-credit bonds, the revenues forgone by the federal government are captured entirely by state and local governments.
However, tax-credit bonds have not been especially well received in financial markets until a few years ago. Investors’ lack of enthusiasm for such bonds probably stemmed from the limited size and temporary nature of most tax-credit bond programs and an absence of rules for separating tax credits from the associated bonds and reselling them. In contrast, "direct-pay" tax-credit bonds—such as certain Build America Bonds issued under the American Recovery and Reinvestment Act—became a significant source of state and local financing in the years during which they were authorized, namely, 2009 and 2010. (A direct-pay scenario allows for the value of the tax credit to take the form of a payment from the Treasury to the state or local government issuing the bond.)
Taxpayers who itemize their deductions may claim a deduction for most state and local taxes. That "taxes-paid" deduction—claimed by slightly fewer than one-third of all tax filers in 2009—provides an indirect federal subsidy to state and local governments because it decreases the net cost to taxpayers of paying such deductible taxes. By lowering the net cost of those state and local taxes, the taxes-paid deduction encourages state and local governments to impose higher taxes and provide more services than they otherwise would and to use deductible taxes in place of some nondeductible taxes.
According to an estimate by JCT, the tax subsidy provided through this deduction was $67 billion in 2011. How much a given state or local government benefits from this deduction depends on the structure of its tax system and the characteristics of the taxpayers who provide revenues to it. (See CBO’s The Deductibility of State and Local Taxes from February 2008 for more information.)
Over the next several years, scheduled changes to tax provisions and the interaction of the regular income tax and the alternative minimum tax (AMT) will change the number of taxpayers who can claim the deduction and the associated loss of federal revenues because the AMT does not allow people to claim the taxes-paid deduction. Under current law:
If certain tax policies that have recently been in effect were extended rather than being allowed to expire, as under current law, the revenue effects of the taxes-paid deduction would be different. Specifically, if all tax provisions expiring after 2012 (including the lower regular income tax rates originally enacted in 2001 and 2003) were extended and the AMT exemption levels were increased for years after 2011, there would be two opposing effects on the taxes-paid deduction:
In its 2011 report on options for reducing the deficit, CBO considered two options for changing the taxes-paid deduction: eliminating the deduction and limiting the deduction to 2 percent of adjusted gross income (see Revenues—Option 5 on pp. 148-149). Under both options, revenues would increase by several hundred billion dollars over the next decade and would have the greatest impact on higher-income taxpayers.