(Editor’s Note: This is Part 2 of Arnold Steinberg’s examination of the politics and logic of federal taxable income deductions for state income taxes and the consequences for California.)
The conspiracy theoreticians discern in the current atmosphere a Trump scheme, because repealing the state income tax deduction will profoundly affect two egregiously BLUE states – California and New York. But the tax policy cadre at the Treasury Department demurs: why should the Federal government encourage and incentivize high tax states like California and New York? Indeed, each time California or New York hikes state income taxes, the net increase for their taxpayers is reduced by as much as 39.6 percent (the current maximum Federal bracket). That’s money the federal government does not get. This means that taxpayer in low tax states are indirectly subsidizing the high-tax states.
Several Republicans in California represent congressional districts carried by Hillary Clinton. If these Members of Congress vote to repeal the deduction for state income taxes, you can bet Democrats will exploit this issue, as they insist the Republican incumbents are voting to shaft their own constituents. That’s because many of the taxpayers who benefit from this itemized deduction are middle-class voters who are vital to the incumbent Republican’s coalition for reelection.
For a long time we have been on dangerous grounds when it comes to “deductibility” of taxes. For example, most states, especially BLUE states, keep raising taxes on tobacco and cigarettes. But such taxes are not deductible. That’s because taxing smokers is socially acceptable, and – I say, without a shred of evidence – that most smokers are relatively lower income and do not itemize, anyway. They have no political clout. Many are probably not registered to vote.
Look at state gasoline taxes. Because the price of gas per gallon has been dropping due to the oil glut, Gov. Jerry Brown and his Democrats in the State Legislature confidently raise the state tax per gallon. They think people will not notice, that they look only at the price at the pump, and the politicians may be right. But note – they raise the tax on gas, although that tax is not deductible on your Federal tax return, and therefore the tax hike is not subsidized by the federal government. So why can’t we start phasing out the deductible of all these taxes?
But the non-deductible taxes on tobacco and gasoline are akin to sales taxes. And general sales taxes are deductible. But for decades you could deduct what you (estimated) you paid each year in sales taxes, and you also could deduct what you (actually) paid in state income taxes. But the pro-tax politicians in Washington recognize that some states have high income taxes, others have high sales taxes, and some have both! They “reformed” the system, so that you have the option of claiming the state and local income tax deduction or state and local sales tax deduction, but not both.
Republicans would be wise to favor not an abrupt end, but, as I shall explain, a phase-out of deductions for state income taxes, state and local sales taxes, and state and local property taxes, as well as mortgage interest. Remember, the more deductions you phase out, then you can phase -in lowered marginal tax rates which can affect incentives, economic growth, income (and income tax revenue). The gentle phase in, rather than an abrupt tax cut, will discourage taxpayers from holding back productive work and income, waiting for the single “big” tax cut in the next taxable year.
Some states have no income tax or a lower income tax than California, but much higher property taxes. An abrupt end to the Federal tax deduction for certain deductions is unfair to taxpayers who rationally relied in their financial planning on, say, deducting property taxes or mortgage interest. Quick adjustments are painful. Instability and volatility are not virtues in this sort of situation: a transitioning adjustment is necessary. So, for example, the first year, you could deduct 90 percent of your state income taxes, the next year 80 percent, and so forth.
Voters approved Proposition 13 and the Great Tax Revolt in 1978. But since then the bureaucrats in California have found many ways to circumvent Proposition 13, and to change the rules to make it easier for voters to pass new taxes. We have even seen the authorities manipulate the ballot title, summary and label of state and local tax hike measures to rig the election outcome. Later this month at Freedom Fest in Las Vegas, I shall discuss how the titans of Big Government pervert the democratic process to raise taxes. You might want to attend. www.freedomfest.com
In the meantime, my Republican friends in the California Congressional delegation should remember – and I reiterate — that eliminating “sacred cow” and “untouchable” tax deductions like the state income tax will facilitate lower marginal tax rates for their constituents. That’s good for them, for everyone.
But who knows how it will all come out in the wash?