(Editor’s Note: Arnold Steinberg looks at the politics and logic behind eliminating the deduction of state taxes for federal tax purposes. In Part 1 today, Steinberg offers a background on tax deductibility. Tomorrow in Part 2 he deals with the tax deductibility and California)
A good friend and solid conservative is concerned that the Trump Administration wants to abolish the Federal tax deduction for state income taxes. Under current tax law, if an individual (or joint) taxpayer itemizes deductions on the Form 1040 Federal tax return, the taxpayer can deduct from the that taxable income the amount paid to the state for its income tax, for example, California income taxes.
Remember that some taxpayers who pay state income taxes still do not have enough personal deductions to itemize. For them, just as for taxpayers who do not pay state income taxes, the matter is moot. Except that someday these folks might pay state income taxes, and itemize.
For taxpayers who presently itemize, their federal tax bill is decreased by the amount of state income taxes paid — multiplied by their marginal Federal tax rate. For example, if you paid California income taxes of, say, $8000, and your Federal tax bracket was, say, 25 percent, you saved $2000 on your Federal tax bill.
Thus, my friend notes that removing the state income tax deduction will effectively increase the Federal tax bill for those California taxpayers affected (in the above example, by $2000). This will hurt the state and its economy, he asserts, by sending more California dollars to Washington. And this is unfair. After all, he correctly explains, California already exports more bucks to D.C. than it gets back from the Feds.
As the late Wm. F. Buckley Jr. noted more than a half century ago, allstates get shafted because of the federal “brokerage fee” to cover the administration of federal grants for assorted programs, many of dubious value, and most inefficient, and the regulations become more oppressive. Bill Buckley’s sainted brother Jim (now 94, but intellectually more adept than most millennial PhDs), who I once helped elect New York’s U.S. Senator, continues to maintain, correctly, that the federal government collects money much more efficiently than it spends it. Jim proposes to help California and the other 49 states by eliminating all Federal grants with their conditions, costs and concomitant bureaucrats, and returning money back to the states directly, with no brokerage costs, and unconditionally. But would any Congress, even Republican, give so much power back to the states and local government?
We are now on a slippery slope, certain Democrats, suddenly and implausibly anti-tax zealots, charge, because: next the Trumpsters will next propose eliminating the homeowner property tax deduction, and then the deduction for home mortgage interest. I confess, a generation ago I created a successful campaign against the ranking Democrat on (and who would have been the incoming chairman of) the powerful House Ways and Means Committee, with supreme authority over tax issues. In that campaign, I raised voter anxiety over his flirtation with ending this sacred cow, the home mortgage interest deduction.
That Congressional campaign was just two years after California’s Proposition 13 passed in 1978 And I can tell you that before Proposition 13, when property taxes were especially oppressive in this state, I never heard an overwhelmed homeowner say, “I don’t mind my latest property tax hike, because property taxes are deductible from my income on my federal tax return.”
The reality is the property tax deduction and the mortgage interest rate deduction are relics. For example, the deduction for mortgage interest dates to the deductibility of interest, in general, that is, the inception of the income tax, at time when homeowner mortgages were uncommon (in contrast to farm mortgages). But that deduction and the property tax deduction were rationalized when the government was post-WWII “encouraging the ‘American dream’ of home ownership,” which it did with even more zest in the late 1990s, then through 2008, precipitating The Meltdown.
There is no more reason for the Federal government to encourage home ownership than to encourage renting. The government should be agnostic. The free market, left alone, would allow for people to choose freely whether owning or renting suits them, and discern market equilibrium. The same logic applies, specifically, to the deduction for mortgage rate interest. The realtors want to keep it, but it makes no economic sense; with its elimination, home prices would adjust, downward at first, but eventually reach a market steadiness that balances owning and renting.
Remember when Congress eliminated the deduction for interest on credit card debt? The lobbyists for banks lost that battle, big time. Guess what? People are still living beyond their means. Credit card debt is at record highs. Of course one secret is that lots of people with high credit card debt do not itemize deductions. Regardless, while some urge deductions for property taxes and mortgage interest as socially desirable, a rationale I reject, is it socially desirable to incentivize credit card debt? No matter, conspicuous consumption, unsubsidized, remains unbounded.