Tax Reform: Tax the Rich—Except Not Us

Norm King
Norm King is a former city manager of three California cities and of the San Bernardino County transportation commission and has taught part-time at USC and Claremont McKenna College. He also served as past director of the Leonard Transportation Center at CSUSB

I do not personally support the Republican tax reform plan, at least in its present form. I do support the components of the reform which would eliminate the federal income tax deduction for state income taxes and property taxes and which would reduce the cap on the deduction of mortgage interest payments from $1 million to $500,000.  If passed I will pay increased federal income taxes. I am not happy about that but these changes will be a good thing for our country both on grounds of equity and economic efficiency.

I am both amused and confused by Governor Brown’s and his followers’ hypocrisy as they protest the elimination and reduction of these deductions. Why hypocrisy? Because these existing tax subsidies allocate benefits which escalate exponentially as one’s income increases.  The last time I checked those on the left opposed policies which widened the wealth gap.

An income tax deduction is no different than Congress allocating an annual “grant” to pay for a portion of the cost of owning a home or a portion of state income taxes.  They are “tax expenditures.”  Whether the subsidy comes in the form of a cash grant or federal tax expenditure funded through a discount of taxes the result is the same – federal revenue is reduced and an equal amount of funds are allocated to qualifying individuals.  The deductions proposed to be eliminated are annual payments to the most affluent – which escalate as ones income increases. The Republican proposal to eliminate these exemptions is aggressively “tax the rich.”  California Democrats view this as a bad thing.

Nationwide these three grant programs – deductibility of mortgage interest, home property taxes and state income tax – cost the federal government around $165 billion per year.  Overall about 88% of these grants go to those with incomes over $100,000 and about 10% to those with income of less than $50,000.  Sounds like a windfall that a good Democrat should wish to eliminate.

The Income Tax Deduction

The tax reform package proposes to eliminate the ability of taxpayers to deduct state income taxes from the federal income tax. The highly progressive California income tax will generate about $83 billion this year and represents about 70% of the state’s general fund spending.  About 20% of this amount (about $16 billion) is refunded by the federal government to those Californians who pay state income taxes.  The top 1% (which total only 160,000 of 16 million tax returns) pays 48% of the total state income tax and it is fair to assume that virtually all of the amount deducted otherwise would have been taxed at an effective rate of 39%, the top federal tax bracket. Therefore California’s top 1% receives somewhere around 75% of the $16 billion which is received by California taxpayers who deduct state income taxes from federal returns.

State Democrats present three arguments against eliminating these cash grants to the rich.  The first is articulated by Sacramento Mayor Darrell Steinberg who urges voters to sign a petition to “protect our middle class” by retaining the state and local tax deductions.  Perhaps this should be rephrased: “Sign a petition to protect the middle class by giving 75% of the subsidy to the wealthiest 1%.”

Secondly, we are told that the elimination of the deduction will result in “double taxation.”  Mayor Steinberg urges us to sign his petition “to ensure that taxpayers are not double-taxed.”  Presumably this means that income spent on taxes should receive favorable treatment versus non-tax expenditures.  Bluff called! If the alleged federal double taxation is a bad thing, by the same logic, the state should eliminate its own double taxation and allow taxpayers to deduct their federal income taxes from their state income tax.  Probably won’t happen.

Finally, we are told that California is a “donor state.”  Congressman Judy Chu: “We are already a high-tax state that delivers more in revenue to the federal government than it receives back,” and “We will end up as an even greater donor state. That’s not fair.”

It is probably true that California, because it is a rich state, does export some taxes to less affluent states.  However, the “donor state” argument supports the argument that citizens of generally less affluent states should subsidize the most wealthy of those who live in a wealthy state. A double standard?  I was under the impression that from a Democratic perspective it is fair to support a tax system by which funds are taken from the more affluent to give to the less affluent.

The Mortgage and Property Tax Exemption

As with the state income tax deduction California benefits more than most other states from the federal property tax and mortgage exemptions. These two exemptions ($68 billion for the mortgage exemption and $33 billion for property tax exemption) also have a pronounced negative effect on housing policy and equity nationwide.

Nationwide 70% of the mortgage deduction subsidy is claimed by the top 20% of earners. According to The Economist, “The country spends more on housing subsidies for 7 million households earning over $200,000 a year than it does on the 55 million making less than $50,000.”

The subsidy  program allocates no funds to the roughly 65% who do not deduct  federal income taxes; allocates nothing to the 37% of Californian who are renters; and provides a progressively larger subsidy to the cost of owning a home  as one’s incomes rises.

In addition to the equity concerns stemming from these deductions it is hard to reconcile their perverse incentives affecting home ownership with left-leaning values. These deductions are taxpayer funded grants which motivate anyone who deducts, especially top earners, to over-consume housing.  Buying bigger homes has a number of important consequences such as increasing greenhouse gas and increasing the consumption of water, lumber, cement, electricity, all of which contradict basic values progressives claim to believe in.

There is one other perverse effect.  Though the real estate industry claims these deductions are necessary to encourage home ownership most of the subsidy is already capitalized into the price of homes.  And, because the higher one’s income the greater the subsidy, those in the higher brackets have a greater financial incentive to over-consume housing than those in lesser brackets. Consequently, market prices are artificially skewed upward leaving those in lower brackets and those who do not deduct to try to afford artificially higher-priced homes without a discount or with a proportionally smaller discount off their property taxes and mortgage payments than provided to more affluent buyers.

The California Fall-Out 

It is obvious why California Democrats are willing to abandon their traditional beliefs about equity and the environment.  They understand that the elimination of these deductions threatens to undermine an already tottering state fiscal system which over-relies on high earners.  Politically and practically it will be harder to raise income taxes on the rich.

More critically, whether income taxes can be raised or not, the elimination of these deductions will provide a substantially greater incentive for the more affluent to flee to lower income tax states. Since 2010 California has experienced a net income outflow of $36 billion to other states. This is only a ripple on the Nevada side of Lake Tahoe compared to what could soon be a coastal tidal wave propelling more of California’s tax base eastward.

Senator Diane Feinstein stated, in regard to the proposal to terminate the state income tax deduction, “I don’t believe California should suffer in order for President Trump to give tax cuts to the rich.”

If she truly believes this she and others of her party should be supporting the components of Trump’s plan to eliminate these state and local tax deductions and reduced the mortgage deduction.

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