How the Tax Code Interacts with State and Local Tax Systems

1. How the Tax Code Interacts with State and Local Tax Systems President’s Advisory Panel on Federal Tax Reform April 18, 2005 Robert M. Schwab College of Behavioral and Social Sciences and Department of Economics University of Maryland

2. Four Key Issues • Links between federal and state income taxes • Deductibility of some state and local taxes • Tax-free municipal bonds • Separation of sources of revenue across levels of government

3. State Income Tax Systems • 43 states and the District of Columbia have state income taxes • No state income tax in Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming • New Hampshire and Tennessee tax only unearned income (for example, interest and dividends) • Tax base • In most cases, federal adjusted gross income • In some cases, federal taxable income

4. Unit of taxation Combined filing Joint/combined filing Joint filing Tax base Social Security Capital gains Unemployment compensation State and municipal bond interest Active duty military pay Retirement/pension income Deductions Exemptions Tax Credits State Deviations from Federal Tax Policy

5. Impact of TRA86 on State and Local Governments • If states did not change tax policy, base-broadening in TRA86 would have increased income tax revenues for many states • New York: $3.3 billion • California: $2.0 billion • States could have undone the effects of TRA86 by changing tax rates • Ladd estimates that the states retained about 40 percent of the windfall

6. Impact of Federal Tax Reforms • Some types of tax reforms would have a major impact on state tax policy • In particular, major changes in the tax base for the federal individual income tax would force states to choose between two strategies: • Adopt similar changes to their state income taxes • Impose significant compliance costs on taxpayers • Clearest case: move from a federal income tax to a federal consumption tax

7. History of Deductibility of State and Local Taxes • Before TRA86 • Property tax • Sales tax • Income tax • TRA86 • Property tax • Income tax • American Jobs Creation Act of 2004 • Property tax • EITHER income tax OR sales tax

8. Tax Expenditure • FY 2003: $46.2 billion • Large in comparison to other tax expenditures • Employer contributions for medical insurance: $113.0 billion • Home mortgage interest: $69.7 billion • Charitable contributions: $29.7 billion

9. Comprehensive Income Tax • Definition of income under a comprehensive income tax • Haig-Simons income = Money value of increase in individual’s power to consume • Actual consumption + net additions to wealth • State and local income taxes are nondiscretionary decreases in an individual’s power to consume, and therefore reduce Haig-Simons income • Argument parallels the argument for a deduction for uninsured casualty losses

10. Subsidy to State and Local Governments • FY 2003: $46.2 billion • Large in comparison to direct federal grants to state and local governments • Department of Transportation: $38.9 billion • Department of Housing and Urban Development: $39.4 billion • Department of Education: $29.2 billion • Rationale for the subsidy: state and local governments provide goods and services that benefit residents of other communities

11. Voting with Their Feet • People “vote with their feet,” i.e., they choose a community that provides a mix of services that best meet their needs • From this perspective, state and local taxes are payments for publicly provided goods and services; they are benefit taxes • Implies that a deduction for state and local taxes would make no more sense than a deduction for expenditures on pants and shoes

12. Impact of TRA86 on State and Local Governments • Recall that TRA86 eliminated the deduction for sales taxes but maintained the deduction for state and local income taxes. • Not much evidence, however, that TRA86 led states to switch from the sales tax to income tax.

13. Percent Distribution ofState Tax Collections

14. Background $2 trillion in outstanding municipal bonds $356 billion of long-term municipal bonds issued in 2002 Interest rates on municipal bonds are lower than rates on private bonds because the interest is exempt from federal taxes Example Corporate bond rate: 5.0 percent 28 percent tax rate Everything else equal, would expect municipal bond rate to be 3.6 percent Supreme Court has held that Congress has ability to tax municipal bond interest. Tax expenditure: $26.4 billion Municipal Bonds

15. Corporate and MunicipalBond Rates

16. How does the rationale for exempting interest on municipal bonds compare to the rationale for allowing a deduction for state and local taxes? • No parallel to the “uninsured casualty loss” argument here • Double subsidy since the interest paid on the bonds would be part of state or local taxes • Interest is tax-exempt • State and local taxes are deductible • Benefits to inframarginal investors.

17. Neutrality • Probably best to think of this issue the same way we think of subsidies to homeowners • Issue there is NOT the deduction for mortgage interest • Instead, the issue is a failure to tax the imputed income from homes • In the case of municipal bonds • Issue is NOT just the exemption for interest on municipal bonds • Instead, the issue is a failure to tax the imputed income from streets in front of homes

18. Neutrality in this context would require • Tax municipal bond interest • Eliminate deduction for state and local taxes • Tax the imputed net income from public capital

19. Separation of Sources of Revenues Across Levels of Government • Some have argued that each level of government should have its own source of revenues • One implication: local governments should rely on a property tax and not an income tax.

20. Argument relies, in part, on the likely excess burden that results from the pyramiding of tax rates that occurs when several levels of government tax the same base. • In a simple partial equilibrium framework, excess burden is proportional to the squareof the tax rate. • Suggests that federal government should tax an activity that is not taxed heavily by lower levels of government

21. Not clear what tax would meet that criteria • States raise roughly 1/3 of their tax revenue from individual income taxes and 1/3 from general sales taxes State Tax Collections, by Source (%)

22. Appendix

23. 2002 State and Local Taxes(billions of current $)

24. Source: economagic.com

25. Maryland Income Tax • Some income that is taxed at the federal level is exempt from Maryland taxes • Interest on U.S. government bonds • Part of retirement/pension payments • Part of active duty military pay • All Social Security benefits • Some income that is exempt at the federal level is taxed at the state level • State and municipal bond interest (except Maryland)

26. Deductions • State and local income tax excluded from itemized deduction • Standard deduction of $3,000 - $4,000 (depending on income) • Exemptions • $2,400 per person • $1,000 for blind and elderly • Credits • Half of the federal earned income credit • Poverty level credit