# Presentation: 372351

## How the Tax Code Interacts with State and Local Tax Systems

- President’s Advisory Panel on Federal Tax Reform
- April 18, 2005
- Robert M. Schwab
- College of Behavioral and Social Sciences and
- Department of Economics
- University of Maryland

## Four Key Issues

- Links between federal and state income taxes
- Deductibility of some state and local taxes
- Tax-free municipal bonds
- Separation of sources of revenue across levels of government

## State Income Tax Systems

- 43 states and the District of Columbia have state income taxes
- No state income tax in Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming
- New Hampshire and Tennessee tax only unearned income (for example, interest and dividends)
- Tax base
- In most cases, federal adjusted gross income
- In some cases, federal taxable income

## State Deviations from Federal Tax Policy

**Unit of taxation**
- Combined filing
- Joint/combined filing
- Joint filing
**Tax base**
- Social Security
- Capital gains
- Unemployment compensation
- State and municipal bond interest
- Active duty military pay
- Retirement/pension income

**Deductions**
**Exemptions**
**Tax Credits**

## Impact of TRA86 on State and Local Governments

- If states did not change tax policy, base-broadening in TRA86 would have increased income tax revenues for many states
- New York: $3.3 billion
- California: $2.0 billion
- States could have undone the effects of TRA86 by changing tax rates
- Ladd estimates that the states retained about 40 percent of the windfall

## Impact of Federal Tax Reforms

- Some types of tax reforms would have a major impact on state tax policy
- In particular, major changes in the tax base for the federal individual income tax would force states to choose between two strategies:
- Adopt similar changes to their state income taxes
- Impose significant compliance costs on taxpayers
- Clearest case: move from a federal income tax to a federal consumption tax

## History of Deductibility of State and Local Taxes

- Before TRA86
- Property tax
- Sales tax
- Income tax
- TRA86
- Property tax
- Income tax
- American Jobs Creation Act of 2004
- Property tax
***EITHER*** income tax ***OR*** sales tax

## Tax Expenditure

- FY 2003: $46.2 billion
- Large in comparison to other tax expenditures
- Employer contributions for medical insurance: $113.0 billion
- Home mortgage interest: $69.7 billion
- Charitable contributions: $29.7 billion

## Comprehensive Income Tax

- Definition of income under a comprehensive income tax
- Haig-Simons income =  Money value of increase in individual’s power to consume
- Actual consumption + net additions to wealth
- State and local income taxes are nondiscretionary decreases in an individual’s power to consume, and therefore reduce Haig-Simons income
- Argument parallels the argument for a deduction for uninsured casualty losses

## Subsidy to State and Local Governments

- FY 2003: $46.2 billion
- Large in comparison to direct federal grants to state and local governments
- Department of Transportation: $38.9 billion
- Department of Housing and Urban Development: $39.4 billion
- Department of Education: $29.2 billion
- Rationale for the subsidy: state and local governments provide goods and services that benefit residents of other communities

## Voting with Their Feet

- People “vote with their feet,” i.e., they choose a community that provides a mix of services that best meet their needs
- From this perspective, state and local taxes are payments for publicly provided goods and services; they are benefit taxes
- Implies that a deduction for state and local taxes would make no more sense than a deduction for expenditures on pants and shoes

## Impact of TRA86 on State and Local Governments

- Recall that TRA86 eliminated the deduction for sales taxes but maintained the deduction for state and local income taxes.
- Not much evidence, however, that TRA86 led states to switch from the sales tax to income tax.

## Percent Distribution ofState Tax Collections

## Municipal Bonds

- Background
- $2 trillion in outstanding municipal bonds
- $356 billion of long-term municipal bonds issued in 2002
- Interest rates on municipal bonds are lower than rates on private bonds because the interest is exempt from federal taxes

- Example
- Corporate bond rate: 5.0 percent
- 28 percent tax rate
- Everything else equal, would expect municipal bond rate to be 3.6 percent
- Supreme Court has held that Congress has ability to tax municipal bond interest.
- Tax expenditure: $26.4 billion

## Corporate and MunicipalBond Rates

- How does the rationale for exempting interest on municipal bonds compare to the rationale for allowing a deduction for state and local taxes?
- No parallel to the “uninsured casualty loss” argument here
- Double subsidy since the interest paid on the bonds would be part of state or local taxes
- Interest is tax-exempt
- State and local taxes are deductible
- Benefits to inframarginal investors.

## Neutrality

- Probably best to think of this issue the same way we think of subsidies to homeowners
- Issue there is ***NOT*** the deduction for mortgage interest
- Instead, the issue is a failure to tax the imputed income from homes
- In the case of municipal bonds
- Issue is ***NOT*** just the exemption for interest on municipal bonds
- Instead, the issue is a failure to tax the imputed income from streets in front of homes

- Neutrality in this context would require
- Tax municipal bond interest
- Eliminate deduction for state and local taxes
- Tax the imputed net income from public capital

## Separation of Sources of Revenues Across Levels of Government

- Some have argued that each level of government should have its own source of revenues
- One implication: local governments should rely on a property tax and not an income tax.

- Argument relies, in part, on the likely excess burden that results from the pyramiding of tax rates that occurs when several levels of government tax the same base.
- In a simple partial equilibrium framework, excess burden is proportional to the ***square**** *of the tax rate.
- Suggests that federal government should tax an activity that is not taxed heavily by lower levels of government

## Not clear what tax would meet that criteria
States raise roughly 1/3 of their tax revenue from individual income taxes and 1/3 from general sales taxes

- States raise roughly 1/3 of their tax revenue from individual income taxes and 1/3 from general sales taxes

|  | Individual Income | Corporate Income | General Sales | Property |
| --- | --- | --- | --- | --- |
| 1985 | 27.1 | 9.7 | 31.5 | 2.1 |
| 1990 | 32.0 | 7.2 | 33.2 | 1.9 |
| 1995 | 31.5 | 7.3 | 33.1 | 2.4 |
| 2000 | 36.1 | 6.0 | 32.3 | 2.0 |
| 2003 | 33.3 | 5.2 | 33.8 | 1.8 |

- State Tax Collections, by Source (%)

## Appendix

## 2002 State and Local Taxes(billions of current $)

|  | State | Local |
| --- | --- | --- |
| Property | 9.7 | 269.4 |
| Sales | 262.4 | 61.7 |
| Individual Income | 185.7 | 17.2 |
| Corporate Income | 25.1 | 3.0 |
| Other | 52.4 | 18.4 |
| Total | 535.2 | 369.7 |

## Source:  economagic.com

## Maryland Income Tax

- Some income that is taxed at the federal level is exempt from Maryland taxes
- Interest on U.S. government bonds
- Part of retirement/pension payments
- Part of active duty military pay
- All Social Security benefits
- Some income that is exempt at the federal level is taxed at the state level
- State and municipal bond interest (except Maryland)

- Deductions
- State and local income tax excluded from itemized deduction
- Standard deduction of $3,000 - $4,000 (depending on income)
- Exemptions
- $2,400 per person
- $1,000 for blind and elderly
- Credits
- Half of the federal earned income credit
- Poverty level credit