Senior Director of State Fiscal Research
The tax bill that House Ways and Means Committee Chairman Kevin Brady plans to release tomorrow will reportedly end the federal deduction for state and local income and sales taxes, but keep it for state and local property taxes. This “compromise” on state and local tax (SALT) deductions — to pay for marginal income tax rate cuts — would be a bad deal for most Americans, as would a full repeal. It likely would harm state budgets nearly as much in the coming years as full repeal, would likely shift more of the load for paying state and local taxes from high-income people to low- and middle-income families, and would fall much harder on some states than others — while probably hurting local government budgets over time, too.
Property taxes are almost all levied by local governments and aren’t a major source of revenue for states, while income and general sales taxes are the two main sources of state tax revenue. Property taxes account for only 2 percent of state tax revenue nationally, while income and sales taxes account for 37 percent and 31 percent, respectively.
So for state budgets, which fund education, health care, transportation, and other services, it’s the deduction for income and sales taxes, which the House tax bill reportedly would end, that really matters. (Currently, taxpayers can deduct either their state and local income taxes or their state and local general sales taxes, whichever are higher. In all 42 states with an income tax, many more filers deduct their income taxes than sales taxes.) As we’ve explained, the deduction makes higher-income filers more willing to support state taxes, because they can reduce the federal taxes that they owe by deducting these state taxes. Repealing the deduction would make it harder for states — many of which already face serious budget strains — to raise sufficient revenues in the coming years to invest in high-quality education, infrastructure, and other priorities crucial to the nation’s long-term economic prospects.
Repealing the income tax deduction would be particularly harmful to state budgets because state income tax revenues tend to grow with the economy, while other major state revenue sources such as sales and excise taxes do not. By reducing support for state income taxes, particularly among high-income taxpayers — a group that tends to be politically influential in states — eliminating the deduction would encourage states to lean more heavily on weaker revenue sources, likely leading to cuts over time in funding for education and other public priorities. Also, state borrowing costs could rise as bond rating agencies react to states’ reduced capacity to generate adequate revenue, raising the cost of needed infrastructure projects.
Further, eliminating the income tax deduction would, over time, likely lead to a shift in who pays state and local taxes even further away from high-income residents to those with middle and lower incomes. That’s because state income taxes are the only major state and local revenue source that’s based on ability to pay, with tax rates in most states rising with income.
States with income taxes and high average incomes would be the hardest hit. They include Maryland, Connecticut, New Jersey, Massachusetts, Virginia, and Oregon, where more than a third of filers claim the deduction, as well as California and New York, where taxpayers in 2015 deducted $80 billion and $52 billion in state and local income tax payments, respectively. But states without income taxes would also be affected. In Chairman Brady’s home state of Texas, which lacks an income tax, over 2 million households — 18 percent of all filers — deducted about $4.8 billion in state and local sales taxes in 2015. They could no longer do so under the “compromise.”
Retaining the property tax deduction might protect local governments from added budget pressures to some extent, but only temporarily. First, if they can’t deduct state and local income taxes, some taxpayers would no longer be able to itemize their deductions and, therefore, wouldn’t be able to deduct their property taxes. Second, facing greater challenges raising revenue, states likely would reduce, over time, support for local governments. (States provide 28 percent of local government revenue, including funding for school districts.) That reduced support would, in turn, force local governments to either accept less funding for schools, parks, libraries, community health centers, and other services or raise local taxes, including property taxes, to make up the difference. These challenges would add to the strain on their budgets in coming years, a period that already may be particularly challenging in part because the White House and congressional Republicans are considering shifting significant new costs to states and localities.
To be sure, eliminating either the full SALT deduction or just the deduction for state and local income taxes would — by itself — make the federal income tax more progressive. But that ignores the actual tradeoff that the House GOP tax plan proposes, which is to end the deduction and use the revenue to pay for marginal income-tax rate cuts, which are more tilted to the top than the SALT deduction. Middle- and low-income people would see little benefit from the overall tax plan, but they would bear much of the brunt of the harm that’s likely done at the state and local levels. That’s a bad deal for most of us.