The state tax deduction

One of the features of the proposed Republican tax overhaul is the elimination of the deduction for state and local taxes. This has caused a good deal of upset from Democrats, who claim it will “hurt the middle class”. Is this true, or is this just spin?

Well, the states that are screaming loudest seem to be New York, California, New Jersey, Illinois and Connecticut. And these are all states which have been under Democratic control for decades. And these are all states that have high state and local taxes. And these are all states with strong public sector unions, who have been strong supporters of state Democratic candidates, who in turn have negotiated generous salaries and pensions for their public sector workers. And these are all states that are in financial difficulty, largely because of huge pension obligations for their public sector union retirees. And these are all states having trouble maintaining their infrastructure, because they are short of money, because they have to pay so much for their public sector employees and their retired public sector employee’s pensions. Is there a message here….?

California’s deficit this year is about $1.6 BILLION dollars. The current estimates put New York state’s deficit at about $4 BILLION next year. New Jersey is projecting a deficit of about $3.6 BILLION within five years.  Illinois just added $5 BILLION in new taxes on its taxpayers, and still projects a deficit of at least $1.3 BILLION next year. Connecticut, at last estimate, expected to run a deficit of at least $1.6 BILLION in the 2017-2018 fiscal year.  Note that we are talking BILLIONS here!

If you think about it, what the state and local tax deduction effectively does is spread a state’s tax liability over everyone else in the country. The state collects a tax, and that tax is deducted from each taxpayer’s taxable federal income, reducing the federal tax they pay and therefore the income to the federal government, which then has to be made up by higher tax rates on everyone else in the country.. So in essence the state and local tax deduction passes part of that state tax burden on to the taxpayers elsewhere in the country.  Not exactly a fair system, I would say.

Of course these high tax states are now faced with a real worry. Several depend heavily on a relatively few very rich residents for much of their tax income, and with the loss of the state and local tax deduction, some of these very rich people may just decide to move to lower-rate states. Just one New Jersey hedge fund investor (billionaire David Tepper) moved to Florida last year and the state lost hundreds of millions in tax revenue.

So on balance I would say eliminating the state and local tax deduction on federal returns is a good thing to do – it makes the system much more fair. States which are improvident can’t pass part of their burden on to everyone else – they need to live with it. States which manage their affairs better aren’t forced by federal tax law to help bail out states that are feckless. And that seems to me right.

But these are Democratically-controlled states, so of course the Democrats are upset at the proposal, but of course they can't admit that their Democratic policies are the reason these states are in such financial trouble (they may not be able to admit that even to themselves), so they have to spin their opposition in some other way - and "hurting the middle class" is what they have chosen.