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

A curious issue is why deductions for state and local income taxes by corporations are not considered a tax subsidy. The general rule for determining whether a tax deduction constitutes an income tax expenditure is whether it reduces the taxable base for purposes of the federal income tax, or more broadly, whether it results in a mismeasurement of income. The exceptions to this rule are provisions such as personal exemptions and standard deductions that constitute part of the progressive structure of the federal income tax and items whose inclusion is not practical (such as imputed net rent on owner-occupied housing). Deducting state and local corporate profit taxes reduces corporate income in the same way that state and local individual income tax deductions reduce individual income. The notion that state and local corporate taxes are part of the firm's cost structure is not persuasive. There seems no more reason that state and local taxes on the profits of corporations should be considered a necessary cost of earning income than is the case of unincorporated businesses or, for that matter, wage earners or investors. Indeed, many of the firms that have become unincorporated in recent years, due to the rapid growth of Subchapter S firms, now have their tax deduction treated as a preference when the same view is not applied to incorporated business. Mere legal form should not alter the view of a subsidy. And the revenue loss from state and local corporate tax deductions is considerable. According to Census data, state and local corporate taxes were $57.5 billion in 2006. At a 35 percent tax rate (and one presumes that firms with state and local corporate profit taxes were taxable for federal purposes), the value of the subsidy is $20 billion.

This view of the corporate state and local income tax deduction as a subsidy, although compelling on economic grounds, has not been included in proposals, such as those by the administration in 1986 or the recent President's Advisory Panel (2005) proposals.

Note that the this argument for counting tax deductions as tax expenditures cannot be as made for property taxes or sales taxes. In measuring income, sales taxes are appropriately deducted as a cost by firms, whether corporate or unincorporated, in determining profit; the subsidy occurs at the individual level when the sales tax is deducted a second time as an itemized deduction by consumers. Property tax deductions by firms and landlords are similarly an appropriate deduction because they are a cost that arises before income is determined, and these deductions are not considered subsidies. The property tax deduction for owner-occupied housing is a subsidy, not because of the property tax per se, but because imputed rent is not included in income. Were imputed gross rent to be included in income, the costs would be appropriately deductible. Whether property tax deductions on owner-occupied homes are treated as a subsidy to state and local activities or a subsidy to home ownership is, however, a legitimate question.

Many economists and tax reformers are critical of deductions for state and local taxes. State taxes provide untaxed benefits, and an income tax that excludes these payments from the base fails to tax comprehensive income. There is an alternative view, however: that they are mandatory payments and should be deducted on those grounds and that costs and benefits do not match closely. The deduction also distorts the level of state and local services and the mix of taxes and fees. Thus, there are two very different types of issues surrounding the deductibility of state and local taxes: those of fairness in the distribution, and those of incentives.

These tax deductions reduce both revenue and the progressivity of the income tax, but, assuming the rate structure could be adjusted to offset these effects as was the case in 1986, to many the important equity issue is the disparate treatment of taxpayers in different states. Although itemized deductions are taken by 35 percent of taxpayers overall, the share itemizing varies substantially across the states (Maguire, 2006). In 2004, the shares itemizing varied from almost 50 percent in Maryland to 17 percent in West Virginia. Only Maryland had a share above 45 percent, but eight states and the District of Columbia had shares of 40 percent to 45 percent. Of the nine states without a broad income tax, only three (Nevada, New Hampshire, and Washington) were among the states with a share above the average, and all of those fell into the 35 percent to 40 percent itemizing. Reuben (2005), studying the issue using data from 2002 before the sales tax option was added, concludes that itemization occurs at higher rates with states with high income and wealth and progressive income taxes. These characteristics persist with the sales tax deduction. According to data in Maguire (2006), only a third of states without an income tax had an itemization rate above the average, while over one-half of those with an income tax did. Thus, even with the optional sales tax deduction in place, having an income tax made itemization more likely.

The addition of the sales tax deduction, which was extended but remains temporary, primarily benefited taxpayers in the states without an income tax (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming). These states only accounted for half of the sales tax deductions claimed, but many are small states, and in the case of other states with an income tax, the net benefit (in excess of the income tax option) is likely small.

One policy concern is that the deduction increases the size of the state and local sector by reducing the state and local tax burden for itemizers. At the same time, some applaud the preferences for income taxes and property taxes, which tend to be more progressive than sales taxes, and even with the sales tax option, the deduction of income taxes dominates the deduction for sales taxes ($202 billion in income taxes compared to $19 billion in sales taxes in 2004). Arguments are also made that federal deductibility mutes distortions in interstate location decisions as a result of differential taxes. While there are concerns that the deduction influences the magnitude of the state and local sector and the mix of taxes, most studies find mixed effects. The two most recent studies, Stotsky (1990) and Courant and Gramlich (1990), like most of the previous ones (which they reviewed), tend to find modest effects. Reuben (2005) points out that no state lowered its sales tax rates after the 1986 revision eliminating deductibility and 15 states had a higher sales tax rate in 1989 than in 1985. No state without an income tax introduced one to substitute for sales tax revenues. However, an argument has been made that the lowering of marginal tax rates was a more serious reduction in the value of income tax deductions than of state and local tax deductions because income taxes were more important for the high-income taxpayers with the largest rate reductions (Stark, 2004). Chirinko and Wilson (2005) review the evidence on interstate substitution, which suggests limited effects of state and local tax differentials on location decisions. These results may suggest to federal tax policy makers that the deduction has no significant distorting effects on states' mix or level of taxes, and should not be an important issue in the consideration of these policies. Concern may instead be directed at equity issues and, if so, the likelihood of retaining the sales tax deduction appears high.

Equity issues may also factor in a number of legislative proposals. Arguments have been made that the elimination of state and local tax deductibility is a good offset for eliminating the Alternative Minimum Tax (AMT), where the major preference is the state and local tax deduction, and the reach of the AMT will increase dramatically without legislative change that is costly in revenue loss. Such proposals were explored by Reuben (2005) and in recent simulations by Burman, Gale, Leiserson, and Rohaly (2007). The President's Advisory Panel's (2005) tax reform proposals proposed to eliminate the deduction along with the AMT. A different approach to addressing inequities across the states was taken by Senator Ron Wyden and Congressman Rahm Emmanuel, who proposed replacing the itemized deduction with a credit for state and local taxes available to all taxpayers in their comprehensive tax reform proposal, introduced in the Senate as S. 1111.

Tax Exempt Bonds

State and local issuance of debt has been going on virtually throughout the existence of the republic. (The history discussed in this section is based on Zimmerman (1991).) Throughout the early to mid 1800s, state public debt began increasing. States turned more and more to aiding private developers. With the industrial revolution, railroad development was actively sought by state and local governments, to the point of serious fiscal problems by 1837. Indeed, the sharp increases in debt issued to aid private developers along with the depression sparked a multitude of restrictions, generally restrictions against lending to private individuals and corporations, and debt limits on general obligation bonds that continue to this day. However, with the limitations came numerous methods for avoidance such as special districts, special funds, and public authorities.