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
1
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
2
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
3
State Deviations from Federal Tax
Policy
• Unit of taxation
– Combined filing
– Joint/combined filing
– Joint filing
• Deductions
• Exemptions
• Tax Credits
• Tax base
– Social Security
– Capital gains
– Unemployment
compensation
– State and municipal bond
interest
– Active duty military pay
– Retirement/pension income
4
Impact of TRA86 on State and
Local Governments
• If states did not change tax policy, basebroadening 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
5
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
6
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
7
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
8
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 HaigSimons income
• Argument parallels the argument for a deduction
for uninsured casualty losses
9
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
10
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
11
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.
12
Percent Distribution of
State Tax Collections
40
35
1985
1990
1995
2000
2003
30
25
20
15
10
5
0
Sales
Income
Corporate
Property
13
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
14
Corporate and Municipal
Bond Rates
18
Moody's Seasoned Corporate Aaa Bonds
16
State & Local 20 year Bond index
Interest Rate
14
12
10
8
6
4
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
Source: economagic.com
15
• 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.
16
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
17
• 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
18
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.
19
• 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
20
• 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
21
Appendix
22
2002 State and Local Taxes
(billions of current $)
State
Local
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
Property
23
Tax Rate at which Taxpayers Benefit from Holding Municipal Bonds
35.00%
30.00%
25.00%
20.00%
15.00%
10.00%
5.00%
1980
1982
1984
Source: economagic.com
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
24
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)
25
• 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
26