The Federal Income Tax Deduction for State and Local Taxes Paid

May 23, 2005. This deduction is a key element of American federalism and a protection against double taxation:

Allowing taxpayers to deduct the state and local taxes that they pay in calculating their federal income tax liability is an essential part of a governmental system in which the federal and state governments have independent sovereign taxing authority. In the American federal system, when people pay state and local taxes, they have less money left over to pay federal taxes. Thus, when it comes to the federal individual income tax, which is based on the “ability to pay” principle, taxpayers should be able to deduct their state and local taxes in determining how much of their income is “taxable” by the federal government.

Despite the fundamental importance of state and local tax deductibility in a federal system such as ours, there are some immediate threats to this concept. In 1986, when the Congress last undertook a thorough restructuring of the federal tax system, the deductibility of state and local income and property taxes was maintained, but that victory is now being eroded by the evolution of the federal Alternative Minimum Tax (AMT) which was intended to help ensure that wealthy taxpayers can not use excessive deductions and tax loopholes to zero out their tax liability. The federal AMT acts as a backstop to the regular federal income tax, imposing a lower set of rates on a much broader tax base that excludes many deductions, including the itemized deduction for state and local income and property taxes. But an increasing number of non-wealthy taxpayers are now being affected by the AMT as the President and Congress have cut the rates of the regular federal income tax relative to the AMT rates, while the AMT exclusion (a sort of standard deduction that is used in calculating AMT liability) has not kept up with inflation. The result is that the AMT, as it is currently structured, serves to undercut the power of the deduction for state and local taxes paid.

Unless steps are taken to reform the federal AMT, a growing number of taxpayers will be affected by it. Ideally, the Congress should remove the deduction for state and local taxes from the calculation of the federal AMT since it is not a tax loophole or a tax preference that taxpayers use to reduce their federal income tax.

In addition to the real threat to deductibility posed by the evolution of the AMT, some Administration officials have floated the idea of completely eliminating the federal income tax deduction for state and local taxes paid as a way to finance other tax cuts. Such a move would amount to a substantial increase in a form of “double taxation” that a pro-Federalism, pro-devolution administration should be opposing rather than supporting.

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