Two steps toward reforming the tax code

Article Highlights

  • The deduction for state and local taxes distorts decision-making by state governments.

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  • Eliminating the deduction for state and local taxes, including property taxes, would raise over $860B over 10 years.

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  • To improve the federal tax system Congress should combine the Marketplace Equity Act with the repeal of this tax subsidy.

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State governors are eyeing the federal tax reform debate closely, as potential reforms to broaden the income tax base could curtail a set of subsidies they currently enjoy -- the deductibility of state and local taxes. But there is another policy debate underway that would have the opposite effect for states -- permitting the collection of sales tax on out-of-state Internet and catalog sales just as they are collected on goods from brick-and-mortar retailers. Combining these two ideas could improve the U.S. tax system on both the state and federal level by creating a level playing field for state and local governments, businesses and taxpayers.

Under current law, taxpayers who itemize their deductions can deduct their state and local income taxes and property taxes. (A temporary provision set to expire this year permits taxpayers to deduct their sales taxes instead of their income taxes if they choose.) The Congressional Budget Office (CBO) says that the "deduction for state and local taxes is effectively a federal subsidy to state and local governments. As such, it indirectly finances spending by those governments at the expense of other uses of federal revenues."

But the policy is worse than just a subsidy to states; it also distorts decision-making by state governments by inducing states to finance activities through higher income-tax rates on high-income individuals (those most likely to itemize). As CBO notes, "The deductibility of taxes could deter states and localities from financing services with nondeductible fees, which could be more efficient."

Eliminating the deduction for all state and local taxes, including property taxes, would raise over $860 billion over the next 10 years relative to current law. Assuming that Congress will continue to extend relief from the Alternative Minimum Tax, the revenue consequence of this subsidy to the states is even greater. Whether this additional revenue should be used to reduce tax rates, reduce the deficit, or pursue a combination of the two is subject to debate, but this change could offset the cost of significant marginal rate cuts. For example, instead of the current tax rate structure of 10, 15, 25, 28, 33, and 35 percent, Congress could reduce individual income tax rates to 10, 15, 25, and 30 percent and still have over $270 billion for deficit reduction or other tax relief.

While such base-broadening would promote economic efficiency, could it hurt state and local governments at precisely the time they are struggling to repair their own budgets? Potentially, but that's where Congress can play an important role in encouraging state tax policy oriented toward economic growth.

Thursday, the House Judiciary Committee (held) a hearing on the Marketplace Equity Act, a bill cosponsored by Representatives Steve Womack, R-Ark., and Jackie Speier, D-Calif., that would permit states to collect the sales tax they are owed when their residents purchase goods online from out-of-state sellers. A companion Senate bill is being championed by Senator Mike Enzi, R-Wyo., and others. Many consumers ignore or don't understand the fact that they owe this tax, even when the retailer doesn't collect it for them. This legislation would overturn the Supreme Court's 1992 decision in Quill Corp. v. North Dakota, which held that states can require sales tax collection only by sellers with a physical presence in the state. Instead, it would permit states to require large out-of-state retailers to collect and remit the taxes owed by their customers.

The benefits of the Marketplace Equity Act are twofold. First, it would facilitate a level playing field between online merchants and brick-and-mortar stores. States that take advantage of this opportunity can ensure that consumers pay the same sales tax regardless of how or where they purchase a good. The Internet is my favorite place to shop, but it doesn't deserve a tax advantage.

Second, a broader sales tax base for states and a federal policy that encourages broad-based consumption taxes are consistent with pro-growth tax policy. What states do with the additional sales tax revenue they collect would be their choice, but one appealing option would be to lower income-tax rates.

By combining the Marketplace Equity Act with the repeal of the federal tax subsidy for state income taxes, Congress could improve the federal tax system and help states improve their tax systems as well. These certainly aren't the only changes necessary in reforming U.S. tax policy, but they are two worth pursuing.

Alex Brill is a research fellow at the American Enterprise Institute. He was formerly the chief economist and policy director to the House Ways and Means Committee.

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