Don't Just Restore the State and Local Tax Deduction

Jason Furman (PIIE)

January 26, 2018

Limiting the state and local deduction as was done in the 2017 tax law was a mistake that will ultimately hurt education, health, and public safety by contributing to the erosion of the tax base in states across the country.

Restoring the state and local deduction as part of a piecemeal set of changes would, however, only compound the damage. Restoring the state and local deduction should be just about the lowest priority for tax policy going forward.

It was a mistake to limit the deductibility of state and local taxes. Republicans started with a fixed $1.5 trillion revenue loss target so that any revenue raised by limiting the state and local deduction went directly into gross tax cuts that, collectively, delivered substantially larger tax cuts to households at the top, widening inequality.

As a result, including the limitation in the 2017 tax law did not raise any revenue or improve progressivity. In fact, including it will inflict substantial collateral damage in the form of increased pressure for states and localities to shift to lower and less progressive revenue sources to keep their tax base from eroding. This, in turn, will reduce vital government services.

Restoring state and local deductibility would cost over $600 billion over the next decade according to the Tax Policy Center. Households making over $1 million would get a $50,000 tax cut, fully half of the benefits.

The average household making less than $200,000 would get only a $30 tax cut—representing less than 10 percent of the total benefit. Some indirect benefits would also trickle down in the form of more supportive state budgets, but these would be small compared to these direct effects.

Committing over $600 billion of scarce budgetary resources in this manner would not make my top 20 list of ways to benefit the working class and the middle class or help education, health or public safety. Instead, by increasing the deficit, it would crowd out resources for these purposes. In fact, with over $600 billion, we could fund universal pre-school and two free years of community college with money to spare left over.

The same logic would also apply to expanding the state and local deduction without fully restoring it. For example, while reinstating the state and local deduction only for households making up to $200,000 or $500,000 would be much cheaper, it would also be regressive within these income groups, would not do much to advance any broader goals and would significantly address any concerns with base erosion.

For example, if Congress raises the top tax rate back to 39.6 percent, then also including a restoration of the full state and local deduction would take away all of that revenue. Just raising rates to 39.6 percent would be far superior policy.

Same for any discrete combination of tax policies that includes restoring the state and local deduction—the same set of policies would be even better without that restoration.

An exception would be if Congress was designing a more fundamental tax reform that targeted explicit revenue and distribution levels. By setting the revenue levels in advance, if the plan ultimately included the restoration of full state and local deductibility that would force even larger gross tax increases to hit the pre-set target. In this case, restoring the deduction might not come at the expense of revenue and progressivity.

The next set of tax debates will have to address the biggest shortcomings of the tax law, notably that we are now raising too little revenue with too large a share coming from middle-class households.

Restoring the state and local deduction should be a relatively low priority in fundamental reform discussions—and would be a major mistake in any piecemeal approach to tax changes.