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Sunday, August 22, 2010

Federal Deductibility of State and Local Taxes

Steven Maguire
Specialist in Public Finance

Under current law, taxpayers who itemize can deduct state and local real estate taxes, personal property taxes, and income taxes from federal income when calculating taxable income. In addition, a temporary deduction for sales taxes in lieu of income taxes is available, though it expired December 31, 2009. The federal deduction for state and local taxes results in the federal government paying part of these taxes through lower federal tax collections. Theory would suggest that taxpayers are willing to accept higher state and local tax rates and greater state and local public spending because of lower federal income taxes arising from the deduction. In addition, there is some evidence that state and local governments rely more on these deductible taxes than on nondeductible taxes and fees for services. 

Repealing the deductibility of state and local taxes would affect state and local government fiscal decisions, albeit indirectly. Generally, state and local public spending would decline, although the magnitude of the decline is uncertain. And, repealing the deduction for state and local taxes would shift the federal tax burden away from low-tax states to high-tax states. Maintaining the current deductibility would continue the indirect federal subsidy for state/local spending. 

Expanding deductibility, such as extending the sales tax deduction option or allowing nonitemizers to deduct taxes paid, would likely increase the subsidy for state and local spending. The sales tax deduction option would primarily benefit taxpayers in states without an income tax that are already itemizing. The effect of allowing non-itemizers to deduct taxes paid would depend on the type of deductible tax. For example, property taxes are only paid (directly) by property owners whereas all consumers pay sales taxes in states that levy a sales tax. The 110th Congress expanded the deduction for property taxes paid by allowing non-itemizers to deduct up to $500 ($1,000 for joint filers) of property taxes paid for the 2008 and 2009 tax years. 

In the 111th Congress, P.L. 111-5, the American Recovery and Reinvestment Act, provides for an above-the-line deduction for sales and excise taxes paid on new vehicle purchases for nonitemizers. The FY2010 budget resolution, S.Con.Res. 13, includes a deficit neutral reserve fund for the permanent extension of the general sales tax deduction option. The President's FY2010 proposed budget included an extension of the sales tax deduction option for the 2010 tax year. The President's FY2011 budget does not include an extension of the sales tax deduction option and proposes a limit on the tax rate at which itemized deductions would reduce tax liability. 

On December 9, 2009, the House approved H.R. 4213, the Tax Extenders Act of 2009, which would extend the sales tax deduction option and the property tax deduction for non-itemizers through 2010. A revised H.R. 4213, The American Jobs and Closing Tax Loopholes Act of 2010, would also extend the sales tax deduction option and the property tax deduction for non-itemizers through 2010.

Date of Report: August 2, 2010
Number of Pages: 14
Order Number: RL32781
Price: $29.95

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