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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.

Reader Discussion

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on November 10, 2017 at 14:21:15 pm

The total elimination of the deductibility of business expenses would cost me money, as I work in a high-cost, low margin industry. Nevertheless, I strongly favor this proposal. It is rare that a change in the tax law can reinforce the basic structure of capitalism, but this one does.

Capitalism is premised on accountability to shareholders and competition among firms. Deducibility of business expenses undermines both. Because the deduction tempers the full force of the burden that business investments impose, the accountability of management for spending becomes more attenuated. And this lack of responsibility is not neutral: managers spend more of the shareholders’ money than they would if they could not slough off some of the costs on people who cannot vote them out of office—taxpayers.

Second, markets are supposed to encourage competition among firms for revenues. But this deduction reduces the keenness of the competition. If the full burden of business costs fell on the sharehohlders, they would have better incentives to evaluate whether they were getting their money’s worth from management. If not, more of them would sell their shares, driving down share prices and putting pressure on management to change its behavior. The deduction for business expenses deprives that market of some of its dynamism….

In fairness, I largely embrace the arguments McGinnis has raised above. Indeed, in a libertarian world without a federal social safety net, I think I would share his views. All else being equal, we wouldn’t make state taxes deductible on federal tax forms.

But this begs the question, is all else equal? I can’t help but notice that high-tax states tend to be higher wealth states. That is, they are states that contribute a disproportionate share of the revenues for running the nation.

Now, I don’t embrace the oft-heard argument that these states deserve the deduction as partial compensation for their good deed. That’s not how progressive taxation works.

But I do embrace the idea that these states are not wealthy by accident (or, at least, not entirely by accident). That is, these states are wealthy in part because they make social investments. They spend more on education. On infrastructure. On health. The resulting social wealth is a function of these investments.

And if we permit firms to deduct the investments they make in generating revenues, why should not the same rationale apply to states? In short, McGinnis appears to assume that state expenses is exogenous to state productivity. I argue that, much as business expenses cannot be regarded as exogenous to business productivity, state expenses cannot be regarded as exogenous to state productivity.

Indeed, today high-tax states are investing heavily in their location and populations and generating tax revenues—which go to prop up the living standards of people in states that have failed to make the same investments. I’d like to see these other states increasing the investments they make in their locations and populations. And one way to encourage that is to let them know that when they do so, at least part of that investment will be returned to them in the form of a federal tax deduction. Under no circumstances would I want to reduce the incentives states have to invest in their regions and populations.

What’s good for the goose is good for the gander.

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nobody.really
on November 10, 2017 at 16:15:12 pm

So shall we view as theorists, or those living in the real world that (often justly cursed) Federalists make? Many more people still itemize than it seems are thought to. It actually doesn't take much to do that, particularly if one has notable medical out-of-pocket.

If the deduction for taxes paid to a state is removed, their is no moral (or theoretical) ground to stand on if the penalization of adding a state REFUND to one's taxable federal income isn't removed. As said above, good for goose, good for gander. Under this proposal, the Federalists are literally saying what's between you (peasant) and your state is strictly that. Fine - remove adding a state refund to one's taxable income. If one purports to support rule of law or, more typically, the notion that they are better decision makers about money that isn't theirs, than "my betters" need to show it by doing the right thing. Federalism is often not about individual liberty & I will always err on the side of the latter.

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Wes
on November 10, 2017 at 16:21:26 pm

Gee, you are indeed a clever wordsmith! Huzzahh!

Who would have thunk it that nobody.really is for high taxes?

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gabe
on November 11, 2017 at 11:08:58 am

"But I do embrace the idea that these states are not wealthy by accident (or, at least, not entirely by accident). That is, these states are wealthy in part because they make social investments. They spend more on education. On infrastructure. On health. The resulting social wealth is a function of these investments. "

Perhaps, we should agree ona definition of "social investments" and wealth.
Here is a slightly different spin on the strength of a high tax state, California whose claim to being the worlds 6th largest economy is dissected and some exposition of those "social investments provided:

http://www.americanthinker.com/blog/2017/11/california_economy_a_measly_37th_behind_michigan_and_ohio.html

Here is another question:

Are government transfers included in California's computation of it's GDP?

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gabe
on November 11, 2017 at 11:14:19 am

Thanks to Brother McGinnis for the shout-out.

nobody's argument is perfectly sensible in principle (Jim Buchanan made an argument like that in 1951 or so, when he was still a conventional economist). But it assumes that the funds will actually be invested, rather than simply consumed. E.g. Medicaid, most of which goes to the states that would be most affected by a SALT repeal, is not an investment; it's consumption. Whether that's good or bad is neither here nor there; but it vitiates the investment argument.

Or try this: NY's prohibition on fracking is an affirmative dis-investment; and if you don't believe that you've never been to Binghamton. Oklahoma etc. and for that matter Pennsylvania have reduced regulations: there's your investment, and the salutary effects have rattled through the economy: should they get an extra tax credit?

I'm not a big fan of the current tax system. But I think reform should focus on supply and production. I take that to be the point of the proposed SALT repeal.

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Michael Greve
on November 11, 2017 at 12:19:55 pm

Just let 'em die, right? The problem with your wet-dreams of anarchy is that under a state of anarchy, life would be "nasty, brutish, and short."

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Trevor Chase
on November 11, 2017 at 12:32:02 pm

OMG, Dawg:

You DON'T really believe that criticizing the amount of gubmint *investments (as some would term these outlays) is tantamount to a call for anarchy, especially Professor Greve, who, if you have read any of his writings, appears to have a far more balanced understanding of gubmint and yes, the need for, and appropriateness of sensible gubmint outlays.

Ya better than this, brudda!

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gabe
on November 11, 2017 at 17:50:44 pm

nobody’s argument …. assumes that the funds will actually be invested, rather than simply consumed. E.g. Medicaid, most of which goes to the states that would be most affected by a SALT repeal, is not an investment; it’s consumption. Whether that’s good or bad is neither here nor there; but it vitiates the investment argument.

Or try this: NY’s prohibition on fracking is an affirmative dis-investment; and if you don’t believe that you’ve never been to Binghamton. Oklahoma etc. and for that matter Pennsylvania have reduced regulations: there’s your investment, and the salutary effects have rattled through the economy: should they get an extra tax credit?

Uh … ok; I guess that’s an option. And likewise we could give credits to states that invest more in education, infrastructure, health, justice, etc.

Likewise, we could eliminate business deductions for business expenditures, and instead offer credits based on case-by-case determinations about which investments some authority deemed productive and which ones the authority thought was a boondoggle. After all, many corporations have swanky corporate offices. Aren’t such “investments” really acts of consumption? Why should they get to deduct those costs against their revenues for purposes of federal income taxes? Etc.

This process seems more cumbersome and rife with potential for abuse than the current system, but I guess it gets at a similar policy objective.

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nobody.really
on December 06, 2017 at 07:49:21 am

The extra charges of a government on the purchasing of property in the form of general country tax can be eliminate easily with in a seven days according to the rules and regulations of a government,If you write an application with the authentic reasons for a elimination of property tax and also attached a legal documents of a property tax pairs after that submitted in the government office by the tax layers which is helpful for you to approved the claim of your property tax in the seven days without any allegations of a government on the application of your property tax ,Remember don’t write any irreverent reasons in the applications of property tax you want to submit in the office of government and also don’t attached any illegal or extra document of property which increase the chances to refuse or neglect your claim application ,So keep it in your mind all the instructions and requirements given to you by the tax layer after concerning this kind of matter according to the current policy of government .
Thanks

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Platinum Accounting

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.