The Deduction for State and Local Taxes: Fair and Efficient Tax Policy | Eastern North Carolina Now

    Publisher's note: The author of this post is Dr. Roy Cordato, who is Vice President for Research for the Carolina Journal, John Hood Publisher.

    Should you ever be taxed on "income" that is not, in any meaningful sense, yours?

    This is the fundamental question facing Congress in deciding whether to eliminate the deductibility of state income and local property taxes from federal taxable income, a policy change proposed by President Trump. Unfortunately, these questions are unlikely to become part of the debate over tax reform. Instead, those who support the president focus on issues that are completely beside the point.

    Some are arguing people living in higher tax states "benefit more" from the current system of state and local tax deductibility than people in low tax states. Those who point out this discrepancy often go on to claim this justifies the elimination of the deduction because these differentials between states actually constitute an "unfair subsidy" to those living in high tax states - New York, Connecticut, and California, for example - by those living in lower tax states like North Carolina, Texas, and New Hampshire.

    But to call this deduction a subsidy of one set of taxpayers by another is putting the cart before the horse. The first question that needs to be answered is, is it appropriate, from either an ethical or economic efficiency perspective, to tax the revenue used to pay state and local taxes in the first place? If it is not, then any talk of subsidization of one group by another as a result of not taxing these revenues is irrelevant. Plus, in a tax setting, to subsidize means either to directly take income from some and transfer it to others or to benefit some categories of taxpayers by allowing them to operate under a different set of rules than all other taxpayers. The deductibility of property and sales taxes does not fit either of these categories.

    Supporters of this change also argue the current system encourages higher taxes at the state and local levels. First of all, it's not clear why this would justify taxing revenue that, from an ethical or economic perspective, shouldn't be taxed in the first place. Once again, the cart is going before the horse. But what makes this a rather bizarre argument, particularly for conservatives, is that their remedy is to expose more of a person's income to taxation at the federal level. They are, in fact, arguing for a transfer of taxing power from state and local governments to the federal government. So much for federalism.

    So again, the question that goes begging is, should you be taxed on income that you are not allowed to take ownership of? As a question of morality or tax fairness, it is difficult to see how the answer could be yes. I don't think anyone would claim that it is morally justified for an individual to be taxed on someone else's income. But this is exactly the case with income that goes to paying state income taxes and property taxes. It is income we are forced to give up all rights to, with no enforceable promise of anything in return. Morally, as opposed to legally, this money is not our own, i.e., we have no choice about how it is allocated. Therefore, to not allow state income taxes to be deductible from federal taxes is the moral equivalent of taxing people on income that is someone else's. In this case, it belongs to the state or local government.

    Beyond the moral argument, basic economics of taxation also suggests state and local taxes should be deductible from taxable income at the federal level. It is widely recognized as a sound principle of tax analysis that only income used for consumption purposes should be taxed. This is the argument behind instituting a national sales tax in place of an income tax. Note that under such a tax, state and local taxes would not be part of the taxable base. The functional equivalent of a sales tax, using income as the base rather than sales, is what is known as the consumed income tax. Under such a system, any income that is not used for consumption purposes is deducted from the tax base. It is the model for state income tax reform endorsed by the John Locke Foundation in 2012.

    Under a properly constructed consumption tax, taxes paid to one level of government should be deducted from the tax base at other levels of government. The late Dr. Norman Turé, a pioneer of supply side tax economics, a leading proponent of the consumed income tax, and widely considered to be the chief architect of Ronald Reagan's 1981 tax cut legislation, describes the proper tax base as follows:

• An individual's revenues from work, saving, and transfer payments received - would be taxable. Outflows associated with earning the revenues (such as net saving, investment, and some education outlays), and income transferred to others... would be deductible. Net taxable income would, in effect, consist of revenues utilized for the individual's own consumption...People should be taxed only on the income over which they retain control and of which they enjoy the benefit.

    Turé then goes on to emphasize that tax payments don't fit this category:

• All payroll and state and local taxes would be deductible as income over which the taxpayer has lost control and transferred to others. State and local taxes are involuntary outflows.

    The debate over whether state and local taxes should be deductible at the federal level largely misses the mark. Discussions guided by concerns about some taxpayers subsidizing others or states being encouraged to tax more heavily, in addition to being unsound on their own terms, fail to consider basic principles of tax fairness and economics. Even more puzzling is that the case for eliminating these deductions is coming from those who typically put these principles front and center.