How the Tax Code Interacts with State and Local Tax Systems

1
How the Tax Code Interacts with State and Local
Tax Systems

• Presidents 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
State Deviations from Federal Tax Policy

• 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

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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

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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

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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

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Comprehensive Income Tax

• Definition of income under a comprehensive income
  tax
• Haig-Simons income Money value of increase in
  individuals power to consume
• Actual consumption net additions to wealth
• State and local income taxes are nondiscretionary
  decreases in an individuals 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

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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.

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Percent Distribution ofState Tax Collections
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Municipal Bonds

• 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

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Corporate and MunicipalBond Rates
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• 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.

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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

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• 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

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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.

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• 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 square of the tax
  rate.
• Suggests that federal government should tax an
  activity that is not taxed heavily by lower
  levels of government

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• 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 ()
Individual Income Corporate Income General Sales Property
1985 27.1 9.7 31.5 2.1
1990 32.0 7.2 33.2 1.9
1995 31.5 7.3 33.1 2.4
2000 36.1 6.0 32.3 2.0
2003 33.3 5.2 33.8 1.8
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Appendix
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2002 State and Local Taxes(billions of current )
State Local
Property 9.7 269.4
Sales 262.4 61.7
Individual Income 185.7 17.2
Corporate Income 25.1 3.0
Other 52.4 18.4
Total 535.2 369.7
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Source economagic.com
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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)

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• 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