27 April 2017

Who Benefits From The Federal Itemized Deduction For State And Local Taxes?

Deducting State And Local Taxes Predominantly Benefits High Income Households

A comment about the impact of a plan to end the deductibility of personal state and local taxes for federal income tax purposes provoked this basically accurate response:
90 percent of the tax increase will be borne by $100K+ households; 40 percent by $500K+ households. Median household income is ~$56K.
The incidence of the tax deductions for mortgage interest and for charitable gifts is quite similar. This makes this look like a tax break for the rich, and to some extent it is one.

Disposable Versus Absolute Income

On the other hand, the federal income tax is basically designed to so that a reasonably equitable share of disposable income is taxed, and it is hard to say that money spent involuntarily on state and local taxes constitutes disposable income.

Harmonizing Cost Of Living

Also, the cost of living varies a great deal from place to place within the United States, and outside of Puerto Rico (whose residents generally don't by federal income taxes unless they are federal employees), the lion's share of that difference is attributable to housing costs.

The property tax component of the state and local tax deduction, together with the mortgage interest deduction, help mitigate the fact that $100,000 per year in San Francisco, for example, might be a pretty modest income when translated into purchasing power, because housing costs are so high, while $100,000 per year in Detroit might translate into far more purchasing power (although the availability of high end goods and services to spend it on might be quite restricted in Detroit):
A salary of $100,000 in San Francisco, California could decrease to $26,742 in Detroit, Michigan. Housing is the biggest factor in the cost of living difference. Housing is 96% cheaper in Detroit.
In a less extreme example, $100,000 a year in San Francisco is equivalent in purchasing power to $46,772 per year in Denver, Colorado, mostly due to housing costs which are 69% cheaper in Denver.

Indeed, the mortgage interest and property tax deductions are quite inadequate to capture the differences in cost of living between places with high housing costs and places with low housing costs. 

These deductions do nothing for people who rent their homes and don't capture higher costs for the principal payments on a home in a place with higher housing costs. But, the exclusive of gain on the sale of a principal residence under federal tax law does provide a tax break for the portion of principal in a home that is due to appreciation in the value of a home. 

Federal tax breaks also don't capture differences in housing costs due to differences in homeowner's insurance costs, which are related to the cost of a home, although not quite proportionately (since a fair amount of a homeowner's insurance policy goes towards general liability insurance for the homeowner).

On the other hand, the deduction of state and local income taxes does far less to harmonize the relative cost of living between two places and accounts for an outsized share of the tax benefit for $500K+ households.

Incentives To Use More Progressive State And Local Taxes

Another key issue in the fairness of the state and local tax deduction is the way that its benefits are affected by the structure of state and local taxes.

Taxpayers in states and localities that raise a larger share of their tax revenue from income taxes and from property taxes benefit disproportionately from this federal income tax deduction.

Taxpayers in states and localities that raise a larger share of their tax revenues from retail sales taxes, excise taxes (e.g. on alcohol, gasoline and tobacco), and from indirect taxation of businesses (such as "business income taxes" and severance taxes on oil and gas extraction), are disfavored by this federal income tax deduction.

Arguably, however, this is a legitimate incentive, because income taxes and real property taxes are much more progressive than retail sales taxes and excise taxes, and the incidence of indirect taxes is hard to determine.

No comments: