How Eliminating the Deduction for State and Local Taxes Promotes Federalism

The total elimination of the deductibility of state and local taxes in the Senate Republican tax plan will cost me money, as I live in the high tax state of Illinois. Nevertheless, I strongly favor this proposal. It is rare that a change in tax law can reinforce the basic structure of our Constitution, but this one does.

Our Constitution is premised on government accountability and our federalism on competition among the states. Deductibility of state and local taxes undermines both.  Because the deduction tempers the full force of the tax burden that states and localities impose, the accountability of state and local legislators for tax and spending becomes more attenuated. And this lack of responsibility is not ideologically neutral: state officials tax and spend more taxpayers’ money than they would if they could not slough off some of the costs on people who cannot vote them out of office.

Second, federalism is supposed to encourage competition among the states for efficient provision of public goods. But this deduction reduces the keenness of the competition.If the full burden of the state tax fell on the citizens of states, they would have better incentives to evaluate whether they were getting their money’s worth in public goods.  If not. more of them would move, putting pressure on the state to change its behavior.  Federalism creates a market for governance, but the deduction for state and local taxes deprives that market of some of its dynamism.

One might wonder why this deduction has survived so long, given that is appears to benefit people mostly in a few high tax states, like California, New York, Illinois, and New Jersey. (Some other states have high taxes but the deduction matters less in them because they have fewer people who make enough money to itemize deductions). The answer may well be agency costs. State officials may generally welcome the deduction and lobby for it, because they want to blunt any competition among the states.

A market for governance is good for citizens, but it makes life for the government officials less easy. Hence state officials, like corporate officials, thus have incentives to engage in cartel-like behavior. Michael Greve has detailed other examples where states acquiesce in federal law that deadens competition among them. Happily, this is one such law whose days may be numbered.