The State and Local Implications of Federal Tax Reform: It Is Imperative That Congress Understand the Negative Impact Some of the Panel's Proposals Would Have on State and Local Governments, Particularly the Elimination of the State and Local Tax Deductions

By Gaffney, Susan; Berger, Barrie Tabin | Government Finance Review, December 2005 | Go to article overview

The State and Local Implications of Federal Tax Reform: It Is Imperative That Congress Understand the Negative Impact Some of the Panel's Proposals Would Have on State and Local Governments, Particularly the Elimination of the State and Local Tax Deductions


Gaffney, Susan, Berger, Barrie Tabin, Government Finance Review


On November 1, the President's Advisory Panel on Federal Tax Reform delivered its much-anticipated report to Treasury Secretary John Snow. President Bush created the Panel in January to recommend options for making the tax code simpler, fairer, and more conducive to economic growth. While the cornerstone of the Panel's report is the repeal of the Alternative Minimum Tax, it also includes many provisions that would be harmful to state and local governments if the recommendations were to become law. The Panel reached consensus on two tax reform platforms--the Simplified Income Tax Plan and the Growth and Investment Tax Plan. Both plans recommend repeal of the AMT, a measure that will cost the U.S. Treasury more than $600 billion over a 10-year period; however, this lost revenue is fully offset by other recommendations. The difference between the plans lies mainly in the tax treatment of business and capital income. This article examines the Panel's recommendations as they relate to state and local governments.

DEDUCTIBILITY OF STATE AND LOCAL TAXES

The most important element of the Panel's report to state and local governments is the recommendation to eliminate the deductibility of state and local income, sales, and property taxes. The report states that "the deduction provides a federal subsidy for public services provided by state and local governments. Taxpayers who claim the state and local tax deduction pay for these services with tax-free dollars. These services, which are determined through the political process, represent a substantial personal benefit to the state or local residents who receive them--either by delivering the service directly or by supporting a better quality of life in their community. The Panel concluded that these expenditures should be treated like any other nondeductible personal expense, such as goods or clothing, and that the costs of those services should be borne by those who want them--not by every taxpayer in the country" (page 83).

GFOA and other state and local government organizations have long fought against the elimination of federal deductibility of state and local taxes. This was a long-fought battle in the 1986 tax reform bill, and came forward again in the 1990s. State and local governments have argued against this provision for many reasons, including the fact that it constitutes federally mandated double taxation of income, property, and purchased goods. But just as importantly, eliminating the deductions would compromise the fiscal autonomy of state and local governments. Given that the federal government continues to impose unfunded mandates on and devolve responsibility to state and local governments, further deterioration of the ability to raise own-source revenues to pay for these mandates would jeopardize many of the services and infrastructure that citizens demand from their local and state governments.

Tim Firestine, CFO of Montgomery County, Maryland, and vice chair of GFOA's Committee on Governmental Debt Management, voiced this concern in testimony given to the Reform Panel in April. Firestine and representatives of other state and local government organizations made it clear that it would be irresponsible to move forward with any tax reform proposals--particularly the elimination of the deduction for state and local taxes--without first determining the impact on state and local governments. No such impacts were mentioned in the Panel's report.

A letter sent to the Panel by GFOA and incorporated into Firestine's testimony noted that deductibility preserves the ability of state and local governments to raise revenues and to provide services, promotes equity in the federal tax system, discourages the migration of businesses and individuals for tax purposes, avoids excessive cumulative federal/state/local income tax rates, and preserves the fiscal autonomy of state and local governments.

TAX-EXEMPT STATUS OF MUNICPAL BONDS

While the proposal does not alter the tax-exempt status of municipal bonds--an issue of concern early in the process--it does recommend "the exclusion from business income for state and local tax-exempt bond interest be eliminated" (page 124). …

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