The Deductibility of State and Local Taxes
The federal individual income tax allows taxpayers to claim a number of so-called tax preferences. Some take the form of exclusions and deductions that reduce taxpayers’ taxable income, and some are credits that may reduce how much tax people owe. All of those preferences decrease the revenues that the federal government raises from a given set of statutory tax rates. Preferences benefit only taxpayers who meet certain eligibility criteria and may alter how those individuals behave toward the tax-preferred activity. They also raise issues of equity regarding otherwise similarly situated taxpayers who do not benefit from such tax-favored treatment.
One such preference is the deduction that the current tax code allows for certain state and local tax payments—those for real estate and personal property taxes along with either income or general sales taxes—subject to the limits that apply to all itemized deductions.1 Deducting state and local taxes under the federal individual income tax subsidizes the revenue-raising activities of state and local governments as long as the revenues are raised through deductible taxes. Because taxpayers who claim the "taxes-paid" deduction may thereby reduce their federal tax liability, the "cost" to the itemizing taxpayer of an additional dollar of revenue raised through deductible state or local taxes is less than a dollar. If that lower cost for taxpayers encourages state and local governments to raise revenue from deductible sources, the reduction in federal tax will constitute an indirect federal subsidy of eligible taxes at the state or local level.
One of the criteria for evaluating whether a federal subsidy is an efficient use of scarce federal resources is the national benefits that it provides. If the taxes-paid deduction encourages state and local governments to use deductible taxes to fund additional services that create spillover benefits to other regions of the country, then the deduction provides a benefit to the federal taxpayers who implicitly finance the preference. If the deduction does not prompt states or localities to change their behavior in that way, or if they use deductible taxes in place of nondeductible levies and do not offer additional services, then the deduction provides a federal subsidy to taxpayers that is not related to state and local services but to the amount of individuals’ income and whether or not they choose to itemize on their tax returns.
During the past few decades, policymakers have limited the taxes-paid deduction on several occasions, and the 2005 President’s Advisory Panel on Federal Tax Reform recommended its elimination.2 That trend toward constraining the deduction was reversed during two recent Congresses, when the deduction was expanded. Changes in the treatment of state and local taxes under the individual income tax continue to be considered, in large part because of the way they would interact with the alternative minimum tax (AMT). The AMT is an additional method of computing tax liability that, unlike the ordinary income tax, does not allow the deduction of state and local taxes and is not indexed for inflation. Consequently, as more and more taxpayers become subject to the AMT as their income rises, fewer of them will benefit from the taxes-paid deduction. Indeed, the deduction is one of the tax preferences that the AMT was designed to constrain; it may thus be a candidate for restriction or elimination as lawmakers look for ways to replace the revenues that would be lost if the AMT was limited or repealed.
This Congressional Budget Office (CBO) paper discusses various issues surrounding the deduction of state and local taxes under the federal individual income tax. (Box 1 briefly describes the data and methods that CBO used in its analysis.) The report examines the deduction and discusses the underlying rationales for the preference and the criticisms leveled at it. The paperalso describes the characteristics of taxpayers who claim the deduction and the geographical distribution of its benefits.
Data and Methods Used in the Analysis
The Congressional Budget Office (CBO) used two data sets—one from the Bureau of the Census and the other from the Internal Revenue Service (IRS)— in its analysis of the taxes-paid (state and local tax) deduction. CBO obtained data on state and local tax revenues from the Census Bureau’s survey of state and local government finances, which reports those revenues by various categories. The share of each type of tax collected was then calculated as a percentage of the government’s total own-source revenues (in this report, all revenues not received from another government or from government-run utilities, liquor stores, or insurance trust funds); receipts from deductible taxes were reported as personal income tax, general sales tax, and property tax revenues. Data on the taxes-paid deduction in the federal individual income tax came from the IRS’s Statistics of Income files.
As part of the analysis, the Joint Committee on Taxation (JCT) prepared estimates of the budgetary effects of five alternatives for changing the deduction: eliminating it, limiting it to a maximum of 2 percent of adjusted gross income, capping the deduction at an indexed dollar amount, replacing the deduction with a credit for currently deductible taxes, and restricting the deduction to real estate taxes. JCT also estimated the budgetary effects of combining those options with changes to the alternative minimum tax (AMT)—specifically, permanently increasing the AMT exemption amounts and brackets to their 2006 levels and indexing them thereafter.
CBO calculated changes in average tax liability by income group and by region using its microsimulation tax model. It assumed that taxpayers would choose whether to take the standard deduction or to itemize on the basis of whichever method minimized their tax liability. In distributional estimates combining the options discussed in this paper with the AMT’s indexation, CBO assumed that a taxpayer would choose to itemize deductions—even if those deductions did not exceed the standard deduction— if itemizing would limit his or her tax liability under the AMT.
As part of its analysis, CBO presents various alternatives for limiting the deductibility of state and local taxes. Using estimates by the Joint Committee on Taxation (JCT) to illustrate how those constraints would affect federal revenues, CBO considers the alternatives both on their own and in the context of possible changes to the AMT. CBO also analyzes how those limits would affect the projected tax liability of various groups of taxpayers—groups based on both income and geography—in 2010 and 2011. By using those years, CBO’s estimates highlight the differences in liability related to deductibility under two conditions: when current law includes the tax provisions enacted since 2001 in their fully phased-in form (in 2010) and when it does not include them, because they have expired (in 2011).
Background on the State and Local Tax Deduction
The preference for state and local taxes is one of the largest tax expenditures in the individual income tax system; estimates by the Joint Committee on Taxation put its cost to the federal government in fiscal year 2007 at roughly $51 billion.3 (Only the exclusion of pension contributions and earnings, the exclusion of employers’ contributions for health care, and the deduction of mortgage interest result in more forgone federal revenues.) The deductibility of state and local taxes, direct grants, and the ability to issue tax-exempt bonds are the primary types of federal subsidy provided to state and local governments. Direct grants are the largest in terms of the federal government’s costs; deductibility and tax-exempt debt each make up less than one-tenth of the estimated amount that will be spent on direct aid in 2008 (see Table 1).4
Estimated Cost of Federal Aid to State and Local Governments, by Aid Source
2007 2008 Direct Grantsa 443.8 466.6 Tax Expenditures Taxes-Paid Deductionb 50.7 43.9 Tax-Exempt Bonds 36.5 39.3Sources: Congressional Budget Office based on Budget of the United States Government, Fiscal Year 2009: Analytical Perspectives (direct grants); and Joint Committee on Taxation, Estimates of Federal Tax Expenditures, 2007–2011, JCS-3-07 (September 24, 2007).
a. The figure for 2008 is an estimate.
b. The taxes-paid deduction allows taxpayers to deduct from their adjusted gross income some of the taxes they pay to state and local governments, including income or sales, real estate, and other taxes. The provision allowing sales taxes to be deducted expired at the end of 2007.
After policymakers made substantial changes to the tax code in 1986 (discussed below), the number of taxpayers who itemized and claimed the taxes-paid deduction dropped (see Figure 1). In recent years, however, that number has risen. In 2004, the most recent year for which data were available, 35 percent of taxpayers itemized deductions, and virtually all of them claimed the taxes-paid deduction on their tax return. Most of the taxes claimed are income taxes (56 percent of the total in 2004) and real estate taxes (36 percent; see Figure 2). Deductions for sales taxes, personal property taxes, and miscellaneous taxes each amounted to 5 percent or less of the total state and local taxes claimed.
Percentage of Taxpayers Who Itemized and Who Claimed the Taxes-Paid Deduction, 1985 to 2004
Source: Congressional Budget Office based on data from the Internal Revenue Service’s Statistics of Income file.
Note: The taxes-paid deduction allows taxpayers to deduct from their adjusted gross income some of the taxes they pay to state and local governments, including income or sales, real estate, and other taxes. The provision allowing sales taxes to be deducted expired at the end of 2007.
Types of Taxes Claimed Under the Taxes-Paid Deduction, 1993 to 2004
(Percentage of all taxes deducted)
Source: Congressional Budget Office based on data from the Internal Revenue Service’s Statistics of Income file.
Note: The taxes-paid deduction allows taxpayers to deduct from their adjusted gross income some of the taxes they pay to state and local governments, including income or sales, real estate, and other taxes. The provision allowing sales taxes to be deducted expired at the end of 2007.
a. Includes sales taxes in 2004.
Rules Governing the State and Local Tax Deduction
Under the rules for determining tax liability for 2007, taxpayers who itemize their deductions may choose to deduct either state or local income taxes or general sales taxes. (As noted earlier, however, beginning in 2008 only income taxes may be deducted.) Taxpayers who claim a deduction for sales taxes may deduct either the actual sales taxes they paid or, using tables that the Internal Revenue Service (IRS) provides, an estimated amount based on their income and the number of exemptions they claim. They may also deduct taxes based on the assessed value of real estate that they own and personal property that is not used for a business.5 The overall effect of those provisions is to reduce the tax liability of filers who pay state and local taxes and claim the deduction.
The taxes-paid deduction is subject to certain limits. First, the total allowable amount of a number of itemized deductions, including that for state and local taxes, may be reduced. For 2007, the reduction, which can be no more than 53-1/3 percent, is calculated by taking 2 percent of any amount that taxpayers’ adjusted gross income, or AGI, exceeds a statutory threshold. The limit is scheduled to change several times in the next few years as the tax provisions enacted since 2001 are fully phased in, by 2010, and then expire, in 2011.
Second, the AMT limits the benefits that taxpayers (and thus, indirectly, governments) receive from the deductibility of state and local taxes. Taxpayers must pay the larger of their liability under the AMT or under the individual income tax. In computing liability under the alternative tax, a taxpayer must include in taxable income several items that are deductible under the ordinary income tax and then subtract the statutory AMT exemption amount; the remaining income is taxed at one of two AMT rates. The largest preference that taxpayers must forgo under the AMT is the deduction for state and local taxes. Without further changes to the alternative tax, many taxpayers will lose the benefit of the taxes-paid deduction.
The legislative history of the deduction for state and local taxes shows two markedly different patterns. During much of the time that the deduction has been in effect, lawmakers focused on clarifying or limiting the preference. Since 2001, though, legislation has expanded the allowable deduction and thus the subsidy provided to taxpayers and to state and local governments.
The taxes-paid preference dates from the enactment of the modern income tax. The Revenue Act of 1913 listed "all national, state, county, school, and municipal taxes paid within the year, not including those assessed against local benefits," as one of various items that taxpayers could deduct in arriving at their taxable income. At the time, the law’s large exemption amounts meant that few people actually paid the income tax, so the preference’s administrative burden and the forgone revenues from the deduction were relatively small.
By the end of World War II, the proportion of the population who paid income taxes had grown dramatically, from about 5 percent when the tax was enacted to nearly 75 percent in 1944. To lessen the complexity of filing, the Congress introduced the standard deduction, which allowed taxpayers to eliminate the recordkeeping necessary to claim any of the itemized deductions. Today, a substantial majority of taxpayers—in 2004, 65 percent—choose to use the standard deduction.
For the most part, legislation enacted during the past 50 years has gradually limited the taxes-paid deduction for those who choose to itemize and claim it. The Revenue Act of 1964 changed the treatment of state and local taxes so that only taxes specifically mentioned in the tax code—namely, taxes on real and personal property, as well as income, general sales, and motor fuels taxes—were deductible. Other legislation clarified the deduction for sales taxes as being limited to a retail tax imposed at a single rate on many classes of items. Because of the considerable recordkeeping necessary to claim a deduction for all of the sales taxes paid, taxpayers were given the option of using a general deduction amount based on their income and household size. A few years later, the Revenue Act of 1978 eliminated the deduction for taxes on motor fuel.
When policymakers discussed major tax reform in the 1980s, one of the many proposals they considered was the elimination of the state and local tax deduction. The Tax Reform Act of 1986, the outcome of those deliberations, repealed only the deduction for general sales taxes; that action came amid concerns about the deduction’s administrative burden for those who did not choose to use the IRS’s sales tax deduction tables and a perception that, for those who did use the tables, the deduction amount was insufficient. However, the American Jobs Creation Act of 2004 partially reinstated the sales tax deduction for 2004 and 2005, allowing taxpayers to choose to deduct either sales taxes (the documented amount they paid or a standardized amount based on their income and household size) or income taxes. Policymakers extended that provision for 2006 and 2007 in the Tax Relief and Health Care Act of 2006.
The Omnibus Budget Reconciliation Act of 1990 enacted a general limit on itemized deductions, which is often called the Pease provision, after Congressman Donald Pease, who proposed it. Under that limit, certain itemized deductions—including that for state and local taxes—were temporarily reduced by 3 percent of the amount that a taxpayer’s adjusted gross income exceeded an indexed threshold, with a maximum reduction of 80 percent of deductible expenses. In 1993, lawmakers made the limit permanent. However, one of the provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) phased out the Pease provision, reducing the limit by one-third for tax years 2006 and 2007 and two-thirds for 2008 and 2009, and then eliminating it for 2010. At the same time, the lower statutory tax rates that EGTRRA put in place reduced the tax benefit from the additional deductions. Because that law expires at the end of 2010, the general limit on itemized deductions will again apply in its original full form beginning in 2011.
Over the next several years, the interaction of inflation, economic growth, and existing provisions in the tax code will also affect the deductibility of state and local taxes. Inflation will increase the number of taxpayers who are affected by the AMT. Unlike the schedule of tax brackets and exemptions for the individual income tax, the brackets and exemptions for the AMT are not indexed for inflation. As a result, the growth of nominal income will cause more and more taxpayers to pay the alternative tax—which, as noted earlier, does not allow a deduction for state and local taxes paid. Policymakers have enacted legislation that temporarily increases the AMT’s exemption amounts, limiting the number of taxpayers subject to the tax. The most recent temporary increase, which was enacted in December 2007 and applies to 2007 tax liabilities, expired at the end of that calendar year.
Current Issues in State and Local Tax Deductibility
An informed discussion of possible changes to the deduction for state and local taxes requires an understanding of several key issues. First, how does deductibility affect a state or local government’s incentive to tax or to provide public services? Second, how does the current composition of state and local government revenues affect the benefits those governments receive from deductibility? Third, how are the benefits from deductibility distributed among taxpayers?
Rationales for the State and Local Tax Deduction
The desirability of a deduction for state and local taxes is closely related to the rationales for fiscal federalism—the systematic division of responsibilities among the federal, state, and local governments in terms of the services they provide to taxpayers. As a general principle, a number of public services are provided at the state and local—not at the federal—level for two reasons. First, smaller governmental units may perform many services more efficiently than larger units because they are better acquainted with the local circumstances in which those services are provided. Second, performing services locally permits greater variation in the type and number of them that can be provided, allowing such services to better satisfy the varying preferences of a diverse population.
That second point is key to understanding a common rationale for and a frequent criticism of the taxes-paid deduction. Under fiscal federalism, the variation permitted in the services that are provided may promote the population’s general welfare with respect to certain kinds of services. For example, to better suit their preferences for street lights, parks, and even public safety, citizens may sort themselves into different communities that provide different amounts of those services. However, some services, such as public assistance and education, provide general benefits that are not easily restricted to those who have financed them and that "spill over" to people in other states and localities. A so-called free-rider problem results: Citizens can live in communities that do not provide such services, and therefore avoid paying for them, but they may benefit from services provided by neighboring communities. Knowing that, state and local governments will tend to provide fewer of those services than they might otherwise.
Financing public goods with large spillover benefits at the federal level would avoid that free-rider problem and the associated underprovision of services by state and local governments. However, the public services that the respective levels of government provide do not break down neatly along those lines. In practice, state and local governments supply a number of services that have nationwide benefits and therefore might be thought of as principally federal in nature. The potential underprovision of such services can be offset if the federal government assists those governments financially, either through direct grants or subsidies.
For several reasons, a deduction for certain state and local taxes may not be the appropriate way to compensate state and local governments for providing services that have national benefits. If deductible taxes are simply charges that cover the value of services desired by taxpayers who have efficiently chosen a particular local community, the rationale for subsidizing those different preferences at the federal level is weak—unless there are significant differences among localities in the cost of providing services. In fact, the original legislation enacting the federal income tax explicitly labeled as nondeductible local taxes paid in return for local benefits. Some deductible taxes, though, are clearly not charges for such benefits. State income taxes, for example, are generally considered to have a redistributive function, although the extent to which they redistribute income varies widely among the states and is small relative to the redistributive capacity of the federal income tax.
Another reason that the taxes-paid deduction may not offset the underprovision of services is that it may simply encourage state and local governments to use deductible taxes in place of nondeductible taxes (levies such as selective—rather than general—sales taxes) without increasing spending for the desired activities. If so, the subsidy does not effectively encourage those governments to provide services that generate national benefits. Some evidence exists to show that deductibility affects the mix of taxes that states and localities choose for financing their activities, but there is relatively little that suggests that deductibility actually increases spending for services.6
Moreover, the deduction may spur state and local governments to provide services that are neither federal in nature nor targeted toward areas of national concern. The indirect nature of the subsidy means that its size and use are not subject to ongoing federal oversight. The lack of monitoring means that state and local governments can use the benefits thus conferred to finance any services they provide to local taxpayers, regardless of the nature of those services. As a result, the subsidy may interfere with the sorting mechanism that otherwise helps keep local public services at levels appropriate to their value to local taxpayers. Because of the subsidy, too many of those services may be supplied, and state and local governments may be bigger as a result.
Those competing factors—the federal government’s interest in assisting state and local governments to provide public services that have benefits beyond their borders and the possibility that such help generates an inefficiently large volume of local services—are the principal pro and con arguments associated with the deduction. Nevertheless, some other issues are also significant.
A common argument for allowing taxpayers to deduct state and local taxes is that of avoiding unfair double taxation. The contention is that resources claimed as taxes by state and local governments are not truly available to taxpayers and thus should not be considered part of the basis for federal taxation. In fact, that argument involves some of the same issues discussed earlier. If state and local taxes are benefit charges and reflect variations in the amount of local public services that taxpayers desire, then such taxes are a form of public consumption and therefore a fair basis for a levy that rests on the concept of people’s ability to pay. If state and local taxes finance services whose benefits spill over to other localities, then the federal subsidy, which has federal benefits, may be justified regardless of the double taxation issue.
Another argument for the taxes-paid deduction involves its effect on marginal tax rates (that is, the total rate on the last dollar of income). By reducing the combined federal, state, and local marginal tax rate on income, the deduction lessens the deterrents to earning income that are inherent in high tax rates. But that reduction in disincentive effects on the so-called individual margin (people’s choice between work and leisure) occurs by changing the incentives on another margin—either the state or local government’s marginal choice between types of taxes (deductible or nondeductible) or the kinds and number of services the governments provide. Whether the combined changes ultimately lessen the overall disincentive effects of the tax code depends on the choices that individuals and governments make.
Distribution of the Benefits from theTaxes-Paid Deduction
How benefits from the deduction are distributed among states and localities depends on the structure of a government’s tax system and the characteristics of the taxpayers who provide revenue to that government. For example, a state or local government that finances its spending by using a larger share of taxes that are deductible under the federal individual income tax receives a larger subsidy through the deductibility provision than an otherwise identical government that finances its spending through a smaller share of deductible taxes. All else being equal, a state or local government whose taxpayers are more likely to itemize deductions also gains a greater benefit than a government whose taxpayers tend to claim the standard deduction.
Distribution of Benefits to State and Local Governments. Revenue sources for state and local governments vary widely. For state governments in 2004, taxes made up about 50 percent of "own-source revenues" for all states.7 However, the share of an individual state’s own-source revenues coming from taxes (which include individual income, general sales, property, and other levies) ranged from a high of about 67 percent in Connecticut to just over 20 percent in Alaska (see Table 2).
Sources of Revenue for State Governments, 2004
Share of Total Potentially Deductible Share of Own-Source Revenues from:a Revenues from Taxes as a Share of: Individual General Property Other Nontax Federal Own-Source State Income Tax Sales Tax Tax Taxes Sources Transfers Revenuesa Incomeb Alabama 15.3 12.9 1.5 18.1 52.2 29.1 16.8 2.0 Alaska 0 0 0.7 19.5 79.8 24.7 0.7 0.2 Arizona 13.8 28.1 2.1 13.4 42.6 27.7 15.8 1.6 Arkansas 16.6 21.1 5.1 12.0 45.2 28.3 21.7 3.1 California 20.3 14.7 1.2 11.5 52.3 19.9 21.4 3.0 Colorado 18.5 10.3 0 9.3 61.9 19.6 18.5 2.1 Connecticut 28.1 20.3 0 18.5 33.1 21.1 28.1 2.7 Delaware 16.8 0 0 34.3 48.8 17.9 16.8 2.6 District of Columbia 17.1 11.9 16.8 19.0 35.3 30.7 33.9 7.3 Florida 0 29.2 0.5 22.4 47.9 22.0 29.7 3.2 Georgia 26.6 19.1 0.3 10.7 43.3 26.0 26.8 2.6 Hawaii 17.7 28.8 0 11.8 41.6 19.8 17.7 2.8 Idaho 16.9 19.3 0 13.1 50.7 24.4 16.9 2.4 Illinois 15.9 15.3 0.1 21.0 47.7 21.3 16.1 1.6 Indiana 19.2 24.0 0 17.0 39.8 25.7 19.2 2.0 Iowa 17.3 14.3 0 14.5 54.0 25.5 17.3 2.1 Kansas 23.8 24.0 0.7 17.1 34.3 26.9 24.5 2.3 Kentucky 19.6 17.1 3.2 18.9 41.2 29.0 22.8 2.9 Louisiana 13.3 16.3 0.2 17.2 52.9 29.4 13.6 1.8 Maine 20.3 16.1 0.8 13.1 49.7 30.9 21.1 3.1 Maryland 24.0 12.3 2.2 17.6 43.8 21.9 26.2 2.6 Massachusetts 27.1 11.5 0 13.1 48.4 20.7 27.1 3.3 Michigan 13.9 18.7 4.9 16.0 46.5 24.1 18.8 2.5 Minnesota 24.5 17.4 2.6 18.6 36.8 20.9 27.1 3.4 Mississippi 10.7 25.0 0.4 15.5 48.4 34.1 11.1 1.5 Missouri 19.7 15.6 0.1 12.8 51.8 27.5 19.8 2.1 Montana 16.2 0 4.9 22.3 56.6 31.1 21.1 3.1 Nebraska 20.9 25.7 0 14.7 38.7 28.4 21.0 2.2 Nevada 0 26.4 1.6 27.6 44.4 15.5 28.0 3.0 New Hampshire 1.2 0 11.0 32.4 55.4 23.6 12.2 1.2 New Jersey 18.0 15.3 0 17.8 48.8 17.8 18.1 2.0 New Mexico 12.2 17.5 0.6 18.1 51.6 29.1 12.8 2.1 New York 27.8 11.3 0 12.5 48.3 30.2 27.8 3.3 North Carolina 22.9 13.3 0 15.2 48.6 24.9 22.9 3.0 North Dakota 5.3 9.2 0 16.1 69.3 22.8 5.4 1.1 Ohio 14.1 12.8 0.1 9.5 63.5 18.9 14.2 2.5 Oklahoma 17.9 12.3 0 19.4 50.4 25.6 17.9 2.4 Oregon 21.0 0 0.1 8.9 70.0 16.9 21.1 3.9 Pennsylvania 13.6 14.4 0.1 18.9 53.0 21.9 13.7 1.8 Rhode Island 17.4 15.6 0 13.6 53.4 27.3 17.4 2.4 South Carolina 16.2 18.2 0.1 10.8 54.7 27.4 16.3 2.1 South Dakota 0 22.3 0 18.2 59.5 31.6 22.3 2.5 Tennessee 0.9 39.2 0 23.8 36.1 36.7 39.2 3.3 Texas 0 23.8 0 23.6 52.6 27.5 23.8 2.2 Utah 16.4 15.2 0 9.2 59.2 21.3 16.4 2.6 Vermont 14.4 8.6 15.0 21.1 40.9 30.5 29.4 4.4 Virginia 25.2 10.1 0.1 12.9 51.8 17.0 25.2 2.8 Washington 0 29.9 5.4 14.0 50.6 19.0 35.4 4.6 West Virginia 12.8 12.3 0 19.9 55.0 28.0 12.9 2.3 Wisconsin 18.8 14.0 0.4 12.1 54.7 19.0 19.2 3.0 Wyoming 0 14.8 4.5 28.9 51.8 37.5 19.3 3.5 All States 16.5 16.6 0.9 15.6 50.5 23.6 17.4 2.1Source: Congressional Budget Office based on the Bureau of the Census’s survey of state and local government finances.
a. All revenues not received from another government or from government-run utilities, liquor stores, or insurance trust funds. Charges such as fees for education and hospitals make up most of the nontax portion of own-source revenues.
b. Total personal income of all state residents.
How much of the tax share of states’ own-source revenues is eligible for federal subsidization through the taxes-paid preference? One measure of the subsidy is the share of all revenues collected by a state (or local) government from taxes that the Internal Revenue Code labels as deductible. That measure is an upper bound on the extent of the federal subsidy; taxpayers do not actually claim all types of legally deductible taxes on their returns—because not all taxpayers itemize and because for some taxpayers, the deduction is limited. In 2004, potentially deductible revenues were about 17 percent of states’ total own-source revenues; shares ranged from a low near zero in Alaska to highs near 40 percent in Washington and Tennessee.8 Revenues from direct federal transfers—at just under 24 percent of revenues from all sources—made up a larger share of total state budgets than did potentially deductible taxes.
Although state governments tend to raise most of their tax revenues from income or sales taxes, local governments depend primarily on property taxes for revenues. About 38 percent of localities’ total own-source revenues came from property taxes in 2004, although among the states, that percentage varied widely by local jurisdiction (see Table 3).9 By comparison with state governments, local governments tend to raise a larger share of their revenues from deductible sources because of their dependence on real estate taxes, which make up the majority of property tax revenues. The average local government raises about 40 percent of its own-source revenues from potentially deductible taxes, with a range of about 15 percent for localities in Alabama and Arkansas to approximately 75 percent for those in New Hampshire and New Jersey.
Sources of Revenue for Local Governments, by State, 2004
Share of Total Revenues from Potentially Deductible Share of Own-Source Revenues from:a Intergovernmental Taxes as a Share of: Individual General Property Other Nontax Transfers Own-Source State Income Tax Sales Tax Tax Taxes Sources Federal State Revenuesa Incomeb Alabama 1.0 12.5 13.7 6.2 66.7 3.5 28.3 14.6 1.2 Alaska 0 7.6 41.4 3.7 47.3 7.6 28.2 49.0 4.3 Arizona 0 11.8 32.3 4.8 51.1 4.5 32.7 32.3 2.7 Arkansas 0.1 19.1 16.3 3.6 61.0 3.7 44.8 16.4 0.8 California 0 6.2 26.0 6.4 61.3 4.3 34.9 26.0 2.6 Colorado 0 15.0 31.4 3.7 50.0 3.3 22.4 31.4 2.8 Connecticut 0 0 72.3 1.4 26.3 2.9 26.5 72.3 4.3 Delaware 3.4 0 33.2 8.7 54.7 2.9 40.4 36.6 1.7 Florida 0 1.7 35.1 8.0 55.2 3.6 24.1 36.8 3.5 Georgia 0 9.8 34.9 5.0 50.3 2.7 27.9 34.9 2.9 Hawaii 0 0 46.2 15.5 38.2 10.4 9.1 46.2 1.8 Idaho 0 0 43.2 2.9 53.8 3.3 36.6 43.2 2.9 Illinois 0 2.5 45.4 6.8 45.3 5.3 25.0 45.4 4.0 Indiana 3.1 0 44.0 1.7 51.3 2.0 33.2 47.1 3.5 Iowa 0.8 6.0 46.1 2.1 45.0 3.7 31.3 46.9 3.5 Kansas 0 7.5 43.3 3.0 46.3 1.6 28.3 43.3 3.8 Kentucky 13.0 0.2 27.1 8.0 51.7 3.4 36.0 40.1 2.2 Louisiana 0 26.4 22.1 4.5 47.0 4.7 29.4 22.1 1.8 Maine 0 0 74.9 2.1 23.0 2.9 28.1 74.9 5.2 Maryland 20.0 0 36.8 9.6 33.6 4.9 23.8 56.7 3.9 Massachusetts 0 0 54.2 2.0 43.8 5.3 28.6 54.2 3.6 Michigan 2.1 0 43.4 2.0 52.4 3.9 42.1 45.6 3.2 Minnesota 0 0.5 34.6 2.5 62.4 4.1 41.7 34.6 2.3 Mississippi 0 0 35.7 2.8 61.5 4.6 38.2 35.7 2.6 Missouri 2.4 13.0 32.7 6.4 45.6 4.2 26.0 35.1 2.6 Montana 0 0 53.0 2.1 44.9 7.4 34.7 53.0 3.0 Nebraska 0 3.4 28.6 6.1 61.9 2.0 18.2 28.6 3.5 Nevada 0 3.5 31.1 15.7 49.8 3.4 33.4 34.6 2.8 New Hampshire 0 0 76.9 1.4 21.6 2.9 32.3 76.9 4.3 New Jersey 0 0 75.5 1.4 23.1 2.6 29.7 75.5 5.0 New Mexico 0 18.0 27.6 5.0 49.4 5.9 48.7 27.6 1.6 New York 6.8 10.3 35.9 8.7 38.3 3.3 29.6 42.7 5.2 North Carolina 0 8.1 32.4 3.0 56.5 2.9 33.8 32.4 2.4 North Dakota 0 5.3 48.5 2.1 44.1 6.3 31.9 48.5 3.1 Ohio 12.7 5.0 40.7 2.3 39.4 4.1 34.6 53.4 4.1 Oklahoma 0 19.2 26.5 3.0 51.3 3.4 33.3 26.5 1.7 Oregon 1.2 0 40.7 9.8 48.4 5.7 33.7 41.8 3.2 Pennsylvania 9.9 0.6 41.2 5.8 42.5 6.1 31.3 51.1 3.7 Rhode Island 0 0 74.1 1.5 24.4 3.9 28.3 74.1 4.8 South Carolina 0 1.2 39.6 6.1 53.1 2.9 28.1 39.6 3.2 South Dakota 0 12.5 43.8 2.9 40.7 6.2 22.9 56.3 3.9 Tennessee 0 7.0 20.3 3.4 69.4 3.3 19.5 27.2 2.7 Texas 0 6.0 46.1 3.5 44.4 3.4 22.9 52.1 4.6 Utah 0 8.0 30.9 6.0 55.1 5.1 27.4 30.9 2.6 Vermont 0 0.2 55.2 1.6 42.9 2.9 49.0 55.2 2.5 Virginia 0 5.1 43.7 12.3 38.8 3.6 30.6 43.7 2.8 Washington 0 7.2 25.8 6.9 60.1 3.8 28.6 33.0 2.9 West Virginia 0 0 41.5 10.3 48.1 4.3 40.6 41.5 2.1 Wisconsin 0 1.8 54.2 1.8 42.3 2.9 38.9 54.2 4.1 Wyoming 0 8.3 31.8 3.1 56.8 2.5 35.3 40.1 4.0 All States 2.3 5.7 37.6 5.7 48.6 4.1 30.4 39.9 3.4Source: Congressional Budget Office based on the Bureau of the Census’s survey of state and local government finances.
Note: The Bureau of the Census collects data on local government finances on a state-by-state basis.
a. All revenues not received from another government or from government-run utilities, liquor stores, or insurance trust funds. Charges such as fees for education and hospitals make up most of the nontax portion of own-source revenues.
b. Total personal income of all state residents.
Using the share of revenues raised by deductible taxes to measure the benefits that state and local governments receive from the deductibility provision does not account for differences in the percentage of total state income that different governments receive as tax receipts. For example, a state government that collects a larger share of the total income of its residents in taxes receives a larger relative federal subsidy than a state government that has the same share of deductible taxes in its revenue mix but a lower average tax burden. Potentially deductible taxes as a share of state and local governments’ own-source revenues and as a share of the total income of state residents are fairly well correlated (see the last two columns of Tables 2 and 3).10 That correlation suggests that most of the variation in the subsidy among the states results from differences in the mix of taxes that the governments choose rather than from differences in their overall tax burdens.
Considering the states on a regional basis reveals a few general patterns, whether measuring the subsidy by the potentially deductible share of revenues or by taxpayers’ total income. Both tend to be larger in the Northeastern states. States in the South and Southwest—with the exception of Florida and Texas, when the sales tax is included in potentially deductible taxes—tend to have relatively small subsidized shares by either measure (see Figures 3 and 4).
Federally Subsidized Shares of Tax Revenues in 2004, by State
Source: Congressional Budget Office based on the Bureau of the Census’s survey of state and local government finances.
Note: The five roughly equal categories group states by the percentages of combined state and local (own-source) tax revenues that were potentially deductible in 2004. (Own-source revenues are all those not received from another government or from government-run utilities, liquor stores, or insurance trust funds.)
Federally Subsidized Shares of Income in 2004, by State
Source: Congressional Budget Office based on the Bureau of the Census’s survey of state and local government finances.
Note: The five roughly equal categories group states by the percentages of total state personal income that represent potentially deductible taxes.
Yet the potentially deductible share of taxes overstates the actual federal subsidy because all taxes that are eligible for deduction are not actually deducted on individuals’ tax returns. A more accurate measure of the potential subsidy to individual state and local governments would compare the amount of the taxes-paid deductions claimed by the jurisdictions’ residents with the total revenues that were collected from those individuals. One problem with such an approach, though, is that in some cases, taxpayers pay state and local taxes to jurisdictions in which they do not reside. As a result, this type of comparison is unlikely to provide much useful information.
Comparing the share of income, sales, and real estate taxes deducted on a national basis avoids that issue and may shed some additional light on the relative subsidy to certain state and local governments. CBO estimates that in 2004, taxpayers claimed, on schedule A of Form 1040, more than 90 percent of both income and property tax payments that were eligible for deduction under the individual income tax—even though on two-thirds of returns, taxpayers did not itemize deductions. In contrast, of the general sales tax revenues estimated to be eligible for deduction under the federal tax, taxpayers claimed less than 10 percent.11
Several factors in combination probably explain the low ratio of sales taxes deducted to sales taxes paid. First, few states impose sales taxes but not income taxes, so the share of the population for whom the sales tax deduction by default would be preferable to the income tax deduction is relatively small. Second, because sales taxes are less progressive than either income or real estate taxes and the likelihood of claiming the deduction rises with income, fewer taxpayers whose potential sales tax deduction is larger than their potential income tax deduction are likely to itemize. Third, as noted earlier, the amounts in the IRS’s sales tax table may understate the actual amounts that individuals pay, but the cost to document those actual payments may be prohibitive. Finally, in 2004 the sales tax deduction had just been enacted and was temporary, which tended to make people less aware of it.
Distribution of Benefits to Taxpayers. Taxpayers who itemize do so in most cases because the value of their itemized deductions exceeds that of the standard deduction. Individuals who choose to itemize and deduct the state and local taxes they have paid decrease their federal tax liability by approximately the amount of their deductible state and local taxes multiplied by their marginal tax rate under the individual income tax. Because the likelihood of itemizing and the marginal tax rate increase with income, taxpayers who benefit from the taxes-paid deduction in its current form are concentrated in the upper part of the income distribution.
In 2004, slightly less than 35 percent of all taxpayers deducted state and local taxes they had paid, but whether a taxpayer claimed the deduction varied considerably according to his or her income. Approximately 20 percent of taxpayers who had income of less than $75,000 took the deduction, whereas more than 85 percent of taxpayers who had income above $75,000 did so (see Table 4). The latter group, who make up roughly the top 20 percent of filers by income, accounted for just over 70 percent of the value of all state and local tax deductions claimed, with an average of $13,218 in deductible taxes per return claiming the deduction.12 Within that group, taxpayers who had income between $75,000 and $100,000 were less likely than those whose income was higher to take the deduction, and the amount of the average deduction (before any phaseout) rose steadily with income.
The Taxes-Paid Deduction, by Taxpayers’ Adjusted Gross Income, 2004
AGI Range (Dollars) Percentage of All Taxpayers Percentage of Taxpayers Taking the Taxes-Paid Deduction Percentage of Total Deductions Claimed Average Taxes-Paid Deduction per Return Claiming the Deduction (Dollars) Percentage ofTax Benefits All Income Categories 0–10,000 18.5 3.8 0.7 2,647 0 10,000–20,000 17.6 10.5 1.8 2,665 0.3 20,000–40,000 24.6 24.7 6.6 3,032 3.4 40,000–75,000 21.9 53.3 19.8 4,708 15.7 75,000 or more 17.5 85.3 71.1 13,218 80.6 Highest Income Category 75,000–100,000 7.7 78.2 14.8 6,779 14.2 100,000–200,000 7.5 90.1 25.1 10,358 29.5 200,000–500,000 1.8 94.2 13.6 22,324 13.6 500,000–1 million 0.3 91.8 5.5 49,952 7.5 1 million or more 0.2 91.2 12.2 201,899 15.9