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The Wall Street Journal reports Republicans in Congress are looking for a way to partially preserve the federal income tax deduction for state and local taxes paid, after many Republicans from high-tax states reacted with alarm to their initial tax proposal, which called for abolishing it.
Democrats are also highly defensive of the provision. The Journal characterizes Senate Minority Leader Chuck Schumer of New York as saying there is no acceptable compromise on the issue.
“Rather than pursuing a partisan path, Republicans should drop this provision,” Schumer said in a statement on Thursday.
But there’s some confusion about what it would mean to preserve the deduction for middle-income families, and an unspoken reason that Democrats want to prevent the deduction from being changed at all.
The state and local tax deduction serves two policy purposes. The obvious one is to ease the federal tax burden on families that pay a lot of state and local taxes.
The other purpose of the deduction is to make it easier for states and localities to levy taxes. If taxpayers get a partial rebate on their federal taxes for every additional dollar of tax that a state or locality collects from them, they’re less likely to object to tax increases or to move away because of them.
This second purpose explains why Democrats are so attached to the tax deduction, even for higher-income taxpayers on whom you might expect them to support a tax increase. Unlike the highly progressive federal income tax, state income taxes have historically been pretty flat. But in the last decade, blue states have become increasingly reliant on “millionaire’s taxes” imposed on very high incomes.
New York has a top tax rate of 8.82%, but married couples only pay it if they make more than $2.14 million. (New York City levies additional taxes on top of that.) In California, state income taxes top out at 13.3%, but only if your family makes at least $1 million a year.
States have had some success collecting revenue from these taxes without inducing too many high-income people to move away, in part because the state and local tax deduction reduces the tax benefit from moving.
If the deduction is abolished even just for the highest earners, that could put blue states under fiscal stress. These taxes would become both more politically problematic and more economically challenging to levy, so states might face pressure to shift the tax burden to the middle class or cut government spending.
As for middle-income families, you could rewrite the tax plan to preserve the deduction for them, but in a lot of cases it wouldn’t do any good. Other provisions in the Republican plan would make changes to the standard deduction and personal exemptions that would render the state and local tax deduction – and other itemized tax deductions – worthless to many families who currently take them.
On Thursday, I walked through why that’s the case, and why the abolition of personal exemptions is the main tax increase on middle-income families in the Republican plan that lawmakers should worry about.
If Republicans want to make their tax plan work for middle-income families, they should consider options like raising the standard deduction even more than they have already proposed, aggressively expanding tax credits for children and other dependents, reducing the bottom tax rate, extending the bottom tax rate to cover more income, or other measures that shift the plan’s benefits away from the rich and toward the middle class. The state and local deduction is not a key distributional issue.
Correction: An earlier version of this story incorrectly reproduced a quote from Sen. Chuck Schumer. He said Republicans should drop their plan to abolish the state and local tax deduction, not that Democrats should do so.