Testimony on Federal Support for State and Local Governments Through the Tax Code

Testimony by Frank Sammartino, Assistant Director for Tax Analysis, before the Committee on Finance, United States Senate

Chairman Baucus, Senator Hatch, and members of the Committee, thank you for the invitation to testify 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. My testimony focuses on two particular aspects of current policy: (1) the use of tax-preferred bonds by state and local governments for subsidizing investment in capital-intensive projects for such things as highways, water resources, and school buildings and (2) the deductibility of state and local taxes.

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.

The most common type of tax-preferred bond is one for which interest income is exempt from federal taxes. 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.

Although a large majority of tax-preferred bonds are traditional tax-exempt bonds, such bonds are a relatively inefficient mechanism for the federal government to transfer funds to state and local governments. Specifically, with tax-exempt bonds, 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. In contrast, 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—for which the value of the tax credit takes the form of a payment from the Treasury to the state or local government issuing the bond—became a significant source of state and local financing in the years during which they were authorized, namely, 2009 and 2010.

The deductibility of state and local taxes provides another means of federal support for state and local governments. Taxpayers who itemize their deductions may claim a deduction for most state and local taxes. That "taxespaid" deduction 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 the staff of the Joint Committee on Taxation, 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. For example, a state or local government that finances its spending by using a larger share of taxes that are deductible under the federal individual income tax receives a larger benefit through the deductibility provision than does an otherwise identical government that finances its spending by using a smaller share of taxes that are deductible. All else being equal, a state or local government whose taxpayers are more likely to itemize deductions also gains a greater benefit than does a government whose taxpayers tend to claim the standard deduction.

In 2009, slightly fewer than one-third of all tax filers claimed the deduction for state and local taxes paid. The amount of those taxes paid generally increased with income, as did the tax saving 1. For previous analysis of these topics, see Congressional Budget from the deduction and thelikelihood that a taxpayer would claim the deduction. For example, approximately 25 percent of tax filers with income under $100,000 claimed the deduction in 2009, compared with over 85 percent of tax filers with income of $100,000 or more.

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 claim the deduction and the associated loss of federal revenues because the AMT does not allow people to claim the taxes-paid deduction. Without further changes to tax law, the number of taxpayers subject to the AMT will rise in 2012 because temporarily higher AMT exemption levels expired at the end of last year; as a result, fewer people will be able to claim the taxes-paid deduction. Also, without further changes to tax law, tax provisions originally enacted in 2001 and 2003 will expire at the end of 2012, increasing regular income tax rates for many taxpayers. Those increases will raise the value of the taxes-paid deduction for those who claim it and increase the associated revenue loss for the federal government. In addition, with the higher tax rates, many taxpayers will shift from being subject to the AMT (even if the current lower AMT exemption levels remain in place) to being subject to only the regular income tax and will therefore be able to claim the deduction for state and local taxes paid.

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. First, the lower regular income tax rates would reduce the tax saving and associated revenue loss for the federal government for taxpayers claiming the deduction. Second, the higher AMT exemption levels would reduce the number of taxpayers subject to the AMT, thereby increasing the number of taxpayers who would claim the deduction.