Across the country, state officials are saying they need to raise taxes to close budget gaps.
States have proposed tax increases for fiscal 2004 of $17.5 billion, which exceeds the previous record of $15 billion, set in 1992, according to the National Governors Association.
Some states are cutting spending, but NGA data show that for the 49 states other than troubled California, spending will rise in 2004 by more than 2%.
One reason legislators favor tax hikes is that the federal tax code encourages them to raise taxes by providing a deduction for state and local income and property taxes.
Taxpayers who itemize get part of their state and local tax burden offset by the federal deduction. That softens the blow of living in a high-tax state and mutes interstate tax competition for mobile residents.
This effect led President Reagan’s Treasury 20 years ago to propose eliminating all deductibility of state and local taxes.
Discussing the proposal, Reagan noted in June 1985: “Perhaps if the high-tax states didn’t have this federal crutch to prop up their big spending, they might have to cut taxes to stay competitive.”
At the time, a study by Harvard’s Martin Feldstein and Gilbert Metcalf found that federal deductibility led to modestly higher state spending. The Tax Reform Act of 1986 repealed just the deductibility of state sales taxes.
Today, evidence of the effect of eliminating deductibility comes from north of the border. In Canada, the lack of federal deductibility of provincial taxes has led to vigorous tax competition, particularly on personal income taxes.
Ontario set the pace with a 30% across-the-board rate cut in 1995 and a 20% cut later in the decade. Other provinces had to take action because interprovincial migration of skilled workers is high.
Alberta responded first by replacing its multiple tax rate structure with a flat rate income tax at 10%, the lowest in the country. British Columbia was next with a 25% across-the-board rate cut in 2001. Since then, Saskatchewan has reduced income tax rates and Quebec has elected a government promising to cut tax rates by 27% over five years.
In each case, the provinces are touting their tax cuts as a way to increase competitiveness and attract greater economic activity.
State policy-makers in the U.S. seem less interested in their competitive position relative to their neighbors. Eliminating federal tax code deductibility would help change that. In addition, it would eliminate the current bias in favor of states having deductible income taxes instead of more efficient, but nondeductible, sales taxes.
Elimination of the federal deduction for state and local taxes could generate about $70 billion that could be used for tax code reforms, such as substantial tax rate cuts and repeal of the alternative minimum tax.
Remember, Dick Armey’s flat tax from the 1990s got rid of all itemized deductions, including state taxes, and dramatically cut tax rates. Such a revenue-neutral tax reform at this time might make sense to budget hawks concerned about the large deficit.
States such as California are currently considering income tax increases, and New York City passed a huge 19% property tax increase last year. It makes no sense for the federal tax code to encourage such anti-growth policies through deductibility.
Without deductibility, some states could still survive with higher taxes, but they would have to provide superior services to continue attracting residents.
Canadian tax policy leaves much to be desired, but on tax competition we should change the federal tax code to get the states acting more like the Canadian provinces.