Limit the Deduction for State and Local Taxes

In determining their taxable income, taxpayers may choose the standard deduction when they file their tax returns, or they may itemize and deduct certain expenses (including state and local taxes on income, real estate, and personal property) from their adjusted gross income, or AGI. (AGI includes income from all sources not specifically excluded by the tax code, minus certain deductions.) Under current law, taxpayers who itemize may also choose to deduct state and local sales taxes instead of state and local income taxes. The total value of certain itemized deductions—including the deduction for state and local taxes—is reduced if the taxpayer's AGI is above $259,400 for taxpayers filing as single or $311,300 for married taxpayers filing jointly in 2016. The thresholds are adjusted, or indexed, to include the effects of inflation.

This option would limit the deductibility of state and local tax payments by capping the deduction at 2 percent of AGI. That change would increase federal revenues by $955 billion from 2017 through 2026, the staff of the Joint Committee on Taxation estimates.

The deduction for state and local taxes is effectively a federal subsidy to state and local governments; that means the federal government essentially pays a share of people's state and local taxes. Therefore, the deduction indirectly finances spending by those governments when federal revenues could be used to fund the activities of the federal government. It also creates an incentive for state and local governments to raise taxes and increase spending—although some research indicates that total spending by state and local governments is not sensitive to that incentive.

An argument in favor of capping the deduction is that the federal government should not provide a tax deduction that subsidizes the spending of state and local governments because revenues from state and local taxes are largely paid in return for services provided to the public. When used to pay for public services, such taxes are analogous to spending on other types of consumption that are nondeductible. Another argument is that the deduction largely benefits wealthier localities, where many taxpayers itemize, are in the upper income tax brackets, and enjoy more abundant state and local government services. Because the value of an additional dollar of itemized deductions increases with the marginal tax rate (the percentage of an additional dollar of income from labor or capital that is paid in federal taxes), the deductions are worth more to taxpayers in higher income tax brackets than they are to those in lower income brackets. Additionally, the unlimited deductibility of taxes could deter states and localities from financing some services with nondeductible fees, which could be more efficient.

An argument against capping the current deduction involves the equity of the tax system as a whole. A person who must pay relatively high state and local taxes has less money with which to pay federal taxes than does someone with the same total income and smaller state and local tax bills. The validity of that argument, however, depends at least in part on whether people who pay higher state and local taxes also benefit more from goods and services provided by states and localities.