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

Another federal tax policy that reduces the benefits for tax exempt interest is the favorable tax treatment for retirement savings, which provides a roughly zero tax rate on assets invested in these plans. The deferral of tax on the savings element in life insurance, if allowed over a long period of time, is close to a tax exemption. One proposal in the Advisory Panel's report would have provided a dramatic increase in investment subsidies by moving to a consumption tax base by expensing investment. The Bush administration has proposed in recent years a significant expansion of tax-free savings plans including a generous, no-strings-attached general savings plan that could eventually allow much of savings to be Invested in tax-free accounts. This would significantly reduce the value of the exemption for state and local bond interest.

As with marginal tax rate proposals, it is not reasonable to expect the federal government to frame its own tax policy structure based on the impacts on state and local borrowing costs. In some cases, however, different mechanisms could have been used that would have been less harmful to the state and local bond market. For example, in 2003, rather than lower the personal tax on dividends and capital gains, the corporate tax rate could have been lowered. This approach would have reduced the corporate debt subsidy, raising the burden on heavily favored debt investment and lowering it on equities. Such an approach would have likely reduced interest rates in general.

These general equilibrium consequences appear because the federal subsidy for state and local borrowing is in the form of an exemption from tax rather than some explicit subsidy (such as a grant) and, therefore, is affected, as discussed above, by other changes. If the preference were allowed by a credit, the benefit would not be affected directly by changes in marginal tax rates, and the benefit could even be adjusted to offset other changes induced by federal policies. State and local governments, however, may reasonably feel that retaining the longstanding exemption provides a more secure grasp on their tax benefit.

In general, less discussion about these implications for the state and local sector has occurred for these changes than for direct proposals affecting tax exempt bonds or state or local borrowing. However, the link between marginal tax rates and the benefits for state and local debt has been recognized in some instances. As the nation was considering raising tax rates to pay for World War II, Treasury Secretary Morgenthau proposed eliminating the tax exemption for both new and outstanding bonds to prevent the windfall from high wartime income tax rates (Zimmerman, 1991, p. 44). In another example of the recognition of these effects, when the government initially proposed to eliminate the dividend tax, a study by California State Treasurer Phil Angelides (2003) estimated the effect on borrowing costs in the nation to sum to $155 billion over ten years.

Finally, to some extent, federal taxes target the same revenue base as the state and local government sector. Indeed, one of the arguments for deducting state and local income taxes was the possibility that high federal tax rates, particularly in the past, left little room for states to impose such taxes. This issue is less important with the much lower current tax rates, and the evidence that behavioral responses are small. There are other tax bases that are common targets. For example, both the federal and state and local governments impose significant taxes on alcohol and tobacco. For the former, the federal tax is about 5.3 percent of sales, while state and local taxes are 3.8 percent on average (based on revenues and sales data, the latter reported in Standard and Poor's Industry Surveys (2006)). For tobacco, state and local taxes amount to 15.5 percent of sales and 24 percent if the tobacco settlement, which acts as an excise tax, is included, while the federal tax is 8.8 percent. While the demand for these goods is relatively inelastic, the tax of one jurisdiction does reduce the revenues of another. A Senate proposal under consideration as of this time (July, 2007) would raise the federal cigarette tax from the current level of $0.39 per pack to $1 per pack, and an increase is still under consideration. An increase to $1 per pack would involve a 14 percent increase in price, and, at an elasticity of 0.4, would reduce consumption by about 5.5 percent and revenues (including the tobacco settlement) by $1.8 billion. (States that have securitized their tobacco settlements would, however, not be affected.)

STATE TAX CONFORMITY AND TAX ADMINISTRATION

Another way in which federal tax policy affects the states is through the common practice of basing state income taxes on federal definitions. Of the 41 states with an individual income tax, only five do not conform to a federal tax measure; nine conform to federal taxable income and the remainder plus the District of Columbia conform to adjusted gross income (Federation of Tax Administrators, 2007). Conformity may be automatic or may require conforming legislation; as a result, some states conform to past versions of federal law. As shown in Table 3, most states also conform to federal taxable income for purposes of federal corporate income taxes, but a number do not conform to specific major provisions of the federal tax code, including the recently enacted provisions for bonus depreciation in 2002 and the qualified production activities deduction in 2004. The production activities provision allows a deduction against taxable income for firms in manufacturing and certain other industries, a deduction that affects the taxable income base as does accelerated depreciation. States may put nonconforming exceptions in their law with respect to both personal and business tax matters. Muntean (2006) discusses, for example, the numerous non-conforming provisions in California's conformity legislation, including health savings accounts and qualified student tuition expenses. Tower and Boyd (2006) suggest that decoupling from federal rules, as well as individual state provisions that do not conform to the federal code, are ubiquitous, identifying 1,666 modifications by the states to the federal code, and 530 state initiatives (special state deductions).

Pomp (1987) reviews both the kinds of conformity and the advantages. The advantages of conformity are: (1) tax returns are easier to complete, (2) taxpayers need to keep only one set of tax records, (3) conformity eliminates separate determinations of legal and factual questions, and (4) conformity reduces the burden on tax administrators. He also defines three types of conformity. The first is absolute conformity, where state taxes are based on adjusted gross income, taxable income, or tax liability. The second is facial-record-keeping: only information on federal tax returns is needed for the state return. The third is non-facial conformity, which occurs when the state has its own separate tax provision (such as a subsidy for investing in the state). The Tower and Boyd data indicate that state initiatives that produce non-facial conformity are less numerous than the other forms of conformity (530 versus 1,666) but do not provide a breakdown of the 1,666.

General conformity means that when the federal government enacts provisions that expand the tax base, states receive a revenue windfall, and when provisions narrow the tax base, they experience a revenue loss. States could offset these effects either by decoupling from federal changes or by changing their tax rates. Politically speaking, changing the tax rates downward with base broadening is easy, and many states made those changes after the 1986 act (Courant and Gramlich, 1990). States are presented with greater difficulties when the base is narrowed, when to conform and maintain revenues requires the politically more difficult step of raising tax rates. As a result, many states have decoupled from provisions that result in revenue losses. Occasionally states' actions in this regard seem inexplicable. Muntean (2006), for example, pointed out that California not only frequently chose different effective dates for conforming legislation, but also did not conform to the tax benefit adopted in 2004 allowing a deduction for certain film and television productions. As a provision largely aimed at Hollywood, federal policymakers could not be faulted if they reconsidered how important this provision was if the state of California does not consider it so.