State & Local Tax Deduction Debate: An Old Story; a New Political Twist

Joel Fox
Editor and Co-Publisher of Fox and Hounds Daily

The debate over the effects of state and local tax write-off from federal taxes in California is not new. Forty years ago, it was part of the historic battle over the iconic tax reduction measure Proposition 13.

Forces opposed to Proposition 13 argued that lowering property taxes meant smaller deductions for California taxpayers on federal taxes resulting in increased tax revenue sent to Washington. The argument had little impact on Golden State residents who feared losing homes to out-of-control property taxes.

The argument has been rekindled with the Trump tax reform plan. Ending state and local tax deduction would affect many Californians who itemize their taxes. In turn, that could hit hard state and local budgets.

The politics involved with ending the state and local tax deductions are interesting to say the least.

Many commentators have focused on the notion that the Trump administration wants to end deductions because they mostly benefit states that generally vote Democratic. Defenders of the move say less wealthy states are subsidizing richer states under the present scheme. It is a matter of tax fairness, they argue, while the revenue collected will help offset other tax cuts in the plan, which will boost the economy.

Regardless of the administration’s motives, the dynamics of California’s tax structure would be greatly affected by ending the deductibility write-off.

California’s budget relies heavily on high-end taxpayers. They have been the target of tax increases in recent years with the passage of Proposition 30 in 2012 and the extension of those top income tax rates for another decade-plus with Proposition 55 in 2016.

Those high income taxes paid as a result of the tax increase are deductible on federal tax forms and many taxpayers in those tax brackets take advantage of the write-off rules. If that provision is eliminated then the tax burden becomes greater on the people California’s tax system relies on to carry the budget load.

Of course, there are many taxpayers who don’t itemize and may be just as eager to vote another tax on the rich as not. Tax the rich is a constant battle cry from the political left in California.

The question is: How will the high-end taxpayers respond to this new burden? Will some of the wealthy taxpayers leave California as motivational guru Tony Robbins did because of the high taxes?

There are other features to the president’s tax proposal that make the political equation uncertain. For example, Silicon Valley millionaires and billionaires might not like the double taxation that eliminating the deductions implies, but they do like features in the plan that lower corporate taxes and allow for bringing cash from overseas home to the United States without suffering a big tax penalty.

In addition, as George Skelton noted in his Los Angeles Times column, ending deductibility may finally force California policymakers to seriously consider changes to a tax structure that performs like a rollercoaster between good economic times and bad. Skelton thinks Senator Bob Hertzberg’s proposal of reducing income taxes and increasing taxes on services may find solid ground.

There is a lot at stake for California as Congress considers the state and local tax deductibility issue.

 

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