How federal policymakers account for the concerns of state and local governments in the formulation of federal tax policy.

INTRODUCTION

In Showdown at Gucci Gulch (Birnbaum and Murray, 1987), chronicling the passage of the Tax Reform Act of 1986, the issues of state and local tax preferences are front and center. The lobbying effort to remove from the Administration's proposal the repeal of state and local tax deductions was "one of the most persistent and pervasive lobbying campaigns of the tax reform story" (p. 113). That effort succeeded in preserving, in this watershed tax reform, the full deduction in the House, and all but the sales tax deduction in the Senate. The final proposal eliminated the sales tax deduction, but in 2004 the deduction was restored as an option to the income tax deduction.

In addition, tax exemption for state and local bonds "was one of the most intensely lobbied parts of the tax bill" (p. 137). The debate, however, was not about the general exemption, but the alarming growth in private activity bonds, which, despite previously enacted restrictions, had surged to two-thirds of the bond market. And even in this case, numerous carve-outs for many types of activities, as well as capped small issue bonds, remained. Although private activity bonds were included in the minimum tax, the general tax exempt preference was not. As the tax reform drama played out, we saw the federal government as protective of the states' tax benefits and slow to react even when these benefits were being abused--an indulgent approach. At the same time, as we show in the following discussion, in many cases federal tax revisions have taken place with consequences for the states, but with little attention to states' concerns.

In order to review both the ways in which federal tax policy affecting the states is made and how important those effects are, it is useful to sort the interaction between federal tax policy and state and local government activity into four broad categories. The first is the explicit preferences granted state and local governments in the federal tax law. The second is indirect effects on the costs of financing state and local activities from apparently unrelated tax provisions. The third is how tax changes interact with the states' desires to conform their tax systems to the federal system to simplify administration and compliance of their own tax systems. Finally, there are federal restrictions on state tax policy; recent provisions are tracked by the Congressional Budget Office under the Unfunded Mandates Reform Act of 1995. Following the discussion of these interactions, the concluding section discusses implications for the attitudes of federal policymakers towards state and local governments in formulating tax policy and the outlook for future changes.

EXPLICIT PREFERENCES IN TAX LAW

The deduction for state and local taxes and exemption of interest on tax exempt bonds have been in the income tax since its beginning and together constitute the main tax expenditures for state and local activity in the federal income tax. As shown in Table 1, out of the $80 billion of official tax expenditures associated with state and local governments, slightly over half (55 percent) are itemized deductions for state and local taxes, and virtually all of the remainder are with tax exempt bond interest. (Note that it is not strictly correct to add the preferences, particularly for itemized deductions, because of interactions.) The tax expenditure list allocates these expenditures by functional category and does not classify the property tax or the exemptions for interest on private activity bonds as supporting state and local government activity.

Two additional items, not in the official tax expenditure list, could be considered subsidies. One is the deduction from the federal income tax base for state and local corporate income taxes, estimated at approximately $20 billion. If corporate income tax deductions were considered a preference, and a case can be made for doing so, the cost would rise by $20 billion, to $100 billion, with tax deductions accounting for almost two-thirds of the total.

The second item that could be considered an income tax expenditure is the exemption from income tax of the profits of state and local business enterprise. These activities are also activities undertaken by the for-profit sector. The Congressional Budget Office (CBO) has estimated, for FY 2002, sales of $287 billion associated with these enterprises (CBO, 2005). The largest share of these sales is for hospitals (23 percent), higher education (21 percent), electric power (19 percent), and water (12 percent). Other activities include gas utilities, lotteries, air transport, solid waste management, parks and recreation, toll highways, liquor stores, special assessments, water transport, and parking. The benefit of excluding this income from the federal corporate tax is uncertain; CBO (2007) has estimated a revenue gain of $0.8 billion from taxing electric utilities; if this same amount relative to revenue occurred for other business enterprises, the total benefit would be $4.2 billion. This number may be too large given the capital intensity of electric power production, but may be understated because of direct funding for activities such as higher education. Given the lack of precedent in taxing these activities, the small size of the effect, and the conferring of similar benefits on the tax-exempt sector, this area seems one unlikely to be subject to legislation. Nevertheless, CBO (2007) included a provision for taxing state electric utilities, where no non-profit counterparts exist, in their budget options study.

Prior estate tax law allowed a credit against the federal estate tax, up to a limit, for state death taxes. If the estate tax repeal enacted in 2001 is allowed to expire, the state death tax credit, which was repealed by the end of 2004, would be restored. In 2001, this death tax credit was $6.3 billion. The credit was actually a free ride for the states, since each dollar of the death credit up to the limit in the tax law (and states generally constructed their taxes to conform to those limits) reduced the federal tax dollar for dollar. The current smaller estate tax now has a deduction, which is less valuable because it reduces the tax by taxes paid times the estate tax rate, and many states no longer have a death tax credit.

The repeal of the estate tax and the elimination of the state death tax credit are examples entirely different from the treatment of preferences in the 1986 reform act. In this case, virtually no attention was paid to the implications for the states. Indeed, the state death tax credit was phased out more rapidly than the estate tax itself. On the other hand, a dollar-for-dollar state death tax credit is an extraordinarily generous federal tax provision that involves a direct transfer of federal revenues to the states, limited only by the size of the federal estate tax.

For a variety of reasons, many believe that the complete repeal of the estate tax may not be feasible. In 2006, a number of proposals were made to substitute a much smaller permanent estate tax for the elimination of the estate tax. Interestingly, elimination of the deduction of state death taxes in computing the federal estate tax was also proposed to limit the revenue impact, a case where tax policy makers were pursuing their own interests without retaining any benefit for the states.

The remainder of this subsection discusses the two major tax preferences--deductibility of state and local taxes and tax exempt interest--in more detail.

Deductibility of State and Local Taxes

Tax subsidies for state and local itemized deductions amounted to $44 billion in FY 2007, or about six percent of state and local tax receipts, based on receipts reported in the Economic Report of the President, 2006. The subsidies vary substantially both by tax and by state (and locality). The largest relative subsidy is for individual income taxes, where the tax expenditure is 11 percent of state and local individual income tax collections. For property taxes, the subsidy is much less, four percent, because property taxes also apply to businesses and owners of rental property (where the tax would be deducted as a business expense in any case) as well as owner-occupied homes. The additional benefit due to the sales tax deduction is less than one percent of sales and gross receipt taxes. This small effect occurs because the current sales tax deduction is allowed as a substitute for income tax deductions and the benefit is measured as the additional deduction allowed because of this option, which tends to be small. (Because disaggregated state and local tax data are only available for 2004, and aggregate data, only for 2006, these estimates assume each revenue source grew at the same rate from 2004 to 2006, and by aggregate GDP growth from 2006 to 2007.)