Cutting back the state tax deduction

As lawmakers look at how to pay for keeping any of the lower tax rates that were temporarily set in place back in 2001 and 2003, they are looking at "base broadening." If you bear in mind that:

       Tax = tax base  x   tax rate

you can see that if you want to be revenue neutral (keep "tax" the same in aggregate for all taxpayers) and lower "tax rate" then mathematically, you need to increase "tax base."  That is, reduce or eliminate some of the 250 special tax rules that reduce taxes (deductions, exclusions, and credits). (Yes, credits are not in the above formula, but they also reduce "tax.")

A 12/6/12 editorial in the New York Times - "Keep the State Tax Deduction" presents the key reason for allowing this deduction for an income tax. To the extent you have a state tax obligation, that is income  you don't have available for paying federal income tax so it should be removed from the base.

While that is a valid point, it is too narrow and we need to move past "one-size-fits-all" types of statements if we are to have effective and appropriate tax reform.

Some state taxes paid should not be lumped into the mandatory exaction / not available for paying income taxes on because not all state taxes are the minimum obligatory amount. One recent high profile example is Mitt Romney. His 2010 federal return indicated he paid about $226,000 in real property taxes.  While that was all a required payment, it represents real property taxes on more than one home and on high value homes. To the extent he deducts that amount (depending on his AMT situation of course), others pay more taxes. Why should others subsidize this wealthy person's state taxes he owes because of his wealth 9which enables him to own high value property with high property taxes)?

There should be a cap on the amount of real estate and personal property taxes. The real property taxes can be tied to regional home prices in different areas in the U.S. And,, this is a large tax expenditure. Per the Joint Committee on Taxation, it "costs" about $70 billion per year.

So far as a deduction for state income taxes paid, there are some policy reasons for perhaps limiting that deduction as well. There are personal decisions on where to live and if a state has high income taxes resulting in large tax deductions, they end up shifting some of the tax to taxpayers outside of the state via the federal tax deduction.

Additional considerations in examining whether the state tax deduction should be reformed:

• It is only available to individuals who itemized deductions (about 1/3 of individuals).
• State tax deductions are not allowed in computing AMT. So today, many individuals do not get a tax benefit for all or part of their state tax deductions.

 All of this is not a new topic. It has been analyzed several times in the past in tax reform activities and some proposals to cut back the deduction have been offered. I even wrote about it back in 2008 when it was a subject of discussion - Goodbye State Tax Deduction, AICPA Tax Insider, 5/8/08.  That article notes pros and cons of the deduction and some of the reform proposals.