How the Trump Tax Cuts Sharpen State Competition

Tax cuts are generally to be welcomed, because they allow people to keep more of their money and provide some constraints on further expansion of the state. But tax cuts are even better when they provide good incentives to individuals and institutions as well. Judged by that standard, the best feature of the Trump tax cuts was the $10,000 cap on the deductibility of state and local taxes. It advanced one of the Constitution’s most important structures for good government—competitive federalism.

Deductibility of state taxes deadens that competition, because it allows states to slough off some of the costs of taxation to citizens in other states. Moreover, it allows states to avoid accountability for the taxes they impose. Given high federal tax rates in some brackets, high income tax payers end up paying only about sixty percent of the actual tax imposed. The federal government and thereby other tax payers effectively pick up the rest of the tab.

If there is any doubt about its effectiveness, just consider the outrage of governors of high-tax states. Governor Andrew Cuomo of New York has blamed it for an exodus of people from New York and a resulting decline in state tax revenues. That’s probably a bit of an exaggeration. Even without the ceiling on the deduction, high-income tax payers had a reason to leave a place like New York City that can take more than 10 percent of their income. But this change deepens the pain and does add to the number of people voting with their feet.

It is true that the ceiling makes some taxpayers pay more, but its dynamic effect is to make it less likely that state and local taxes, particularly highly visible state income taxes, will be raised and more likely that they will be cut. High-income tax payers in suburbs will now be more likely to vote on the issue of  taxes than on cultural attitudes. A test case for this will come in my state of Illinois where the new Governor, J.B. Pritzker, wants to get rid of the state constitutional provision mandating a flat tax. With the elimination of the ceiling, taxpayers now recognize that they will have to bear the full brunt of the high income tax rates that he wants to impose and are more likely to call on their representatives to vote down the amendment.

To be sure, some Democratic members of Congress have called for the elimination of the ceiling on state and local tax deductibility. But they may have difficulty following through, given that the benefits of elimination would go almost entirely to high income tax payers and thus undermine their mantra of soaking the rich.

This tax change should be just the beginning of federal efforts to sharpen competition among the states. Other changes include allowing states to experiment more in programs where costs are shared with the federal government, like Medicaid. Even more radically, if the federal government provides money to the states, it could so more by per capita block grants that allow states to choose what programs to embrace.

The market for governance among the states that federalism creates will never work as efficiently as product markets, because the cost of leaving a state is higher than choosing a different product.  But federal law could make it work a lot better than it does.