I have long been aware of the many convoluted effects of our federal tax code, but one aspect of the code has always bothered me because it is rarely mentioned nor has it been part of any tax reform proposal or legislation. While studying the new proposals for tax reform, it is surprising to find that aspect being addressed in the congressional version of tax reform which will surely be taken up this coming year.
The deductibility of state income taxes on the federal return is what I’m referring to. In a nutshell, because state income taxes can be deducted on a federal return, the Federal Government ends up subsidizing a meaningful portion of the tax revenues collected in high income tax states, rendering no support to states without an income tax and little help to low-tax states. This unfair result serves to support state and municipal tax increases; in effect helping some state and municipal governments more than others. On an aggregate basis, this federal subsidy is certainly sizeable and probably represents a significant portion of our federal deficit in spite of its unfairness. The “blue” states have been the clear beneficiaries of this provision and as the same political party controlled federal tax legislation, it was easy to leave well enough alone. The recent election has turned the tables and it appears that some of these long standing inequities will be corrected.
On another score, the tax reform proposal suggests doing away with the deduction for real property taxes on one’s home as well as the deduction for mortgage interest.
Clearly, the new framers of tax reform want to take Uncle Sam out of the business of creating certain kinds of tax motivated behavior, like unnecessary taxing at the state and county level as well as the propensity for buying a bigger home.
The offset to these changes will of course be a lower tax rate for individuals, so the net effect will not be as catastrophic as it may seem. Nevertheless, the results of this fundamental change are apt to be dynamic, and one should pencil out the effect for him/herself.
Of course, there are many other tax proposals included in the reform package which we are likely to comment on in the future. This one is “sneaky” and is worth contemplating.