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CBO: The Deductibility of State and Local Taxes
Taxpayers who itemize deductions on their Federal Income Tax Returns may, with some limitations, deduct payments for certain State and Local taxes from their reported income. About 35 percent of taxpayers opted to itemize deductions on their Federal Income Tax Returns in 2004, and nearly all of them claimed a deduction for their State and Local taxes they paid. Income taxes (56 percent) and real estate taxes (36 percent) made up the majority of the State and Local Tax Deductions claimed. The "taxes paid" deduction, which has been in place in some form since the inception of the modern Federal Income Tax, not only benefits the taxpayers who claim it but also provides an indirect federal subsidy to the state and local governments that levy deductible taxes -- because it decreases the net cost to taxpayers paying those taxes. By lowering the net cost of certain state and local taxes, the taxes paid deduction may encourage state and local governments to impose higher taxes and provide more services than they otherwise would. Whether that indirect subsidy is an efficient use of federal resources depends on the nature of the benefits from any additional services. To the extent that state and local taxes are payments by residents of those jurisdictions for services that they themselves receive from their state and local governments, the rationale for a federal subsidy is weak. In contrast, if state and local taxes pay for services that have spillover benefits that are regional or national in nature, then a federal subsidy may be desirable to ensure that an adequate volume of such services is produced. Some evidence suggests that state and local governments may respond to the taxes-paid deduction not by imposing higher taxes but by simply using deductible taxes in place of some nondeductible taxes. Deductible taxes measured as a share of states’ total revenues or as a percentage of their total income vary considerably among the states and do not appear to be related to the overall level of taxation. In general, deductible taxes make up a larger share of the revenues of local governments than of state governments. Higher-income households are more likely than low- or moderate-income households to benefit from the taxespaid deduction. The probability that taxpayers will itemize (which is necessary to claim the taxes-paid deduction), the amount of state and local taxes paid, and the reduction in federal income taxes for each dollar of state and local taxes deducted all increase with income. The state and local tax deduction reduced federal revenues by an estimated $50 billion in fiscal year 2007. Over the next several years, scheduled changes to tax law and the interaction of the regular income tax and the alternative minimum tax (AMT) will change the number of taxpayers who claim the deduction and the associated loss of federal revenues. The amount of that loss is projected to diminish through 2010, because more taxpayers will pay the AMT, which does not allow people to claim the taxespaid deduction. The number of taxpayers subject to the AMT will rise because, unlike the regular income tax, the AMT is not indexed for inflation. Without changes in the tax code (such as the temporary increases in the AMT exemption level that have been enacted in recent years), more and more taxpayers will pay the AMT as their nominal income grows. The scheduled expiration after 2010 of tax provisions enacted in 2001 and 2003 will boost income tax rates for many taxpayers, raising the value of the taxes-paid deduction for those who claim it and increasing the associated revenue loss for the federal government. The AMT is a parallel income tax system with fewer exemptions, deductions, and tax rates than the regular income tax. Taxpayers potentially subject to the AMT must calculate their taxes under both the regular income tax and the AMT and pay the higher amount.
	asked by grandpa24551, 2/21/2008
Categories: Financial Planning for Retirement, Tax Planning

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