Major Fight Likely Over Killing Deductions for State, Local Taxes

President Reagan’s proposal to eliminate the federal deductions for state and local taxes quickly became the most controversial part of his sweeping tax reform package as debate began Wednesday on Capitol Hill.

“It’s the hottest issue we are working with,” said Rep. Robert T. Matsui (D-Sacramento), a member of the House Ways and Means Committee, which originates tax legislation.

Already, Rep. Thomas J. Downey (D-N.Y.) noted, coalitions are developing to save the deductions for income, sales and property taxes. One such group, for example, includes not only lawmakers from high-tax states such as California and New York but lawmakers from low-tax states such as Texas and Oklahoma, who, in exchange, want help in saving imperiled tax breaks for the oil and gas industry.

Deductions Become Emotional Issue

The key deductions immediately became an especially emotional issue because substantial amounts of money are involved for many individual taxpayers as well as local governments. Those taxes are the largest single tax preference eliminated under Reagan’s plan, worth an estimated $40 billion in 1990.

Similarly, there is much at stake for the Administration, which contends that retaining the deductions would emasculate the President’s tax package.

“We looked at the cost of restoring the state and local tax break,” one Treasury official argued, “and, instead of doubling the personal exemption to $2,000, we would have had to leave it at $1,000.”

Politicians from both parties, as well as tax experts called to testify at a congressional hearing Wednesday, attacked the proposal to eliminate the deductions on several grounds. They charged it would:

--Unfairly penalize many taxpayers in states with high income or property taxes.

--Pressure many state and local governments to reduce funding for education and other social services.

--Increase tax competition among states seeking new industry.

--Depress real estate values and prevent many young couples from buying first homes because it becomes more expensive to own a house when property taxes are not deductible.

--Step up migration from cities to the suburbs because taxes to pay for welfare and other services, traditionally highest in the cities, would spiral ever higher.

Repealing the deductions subjects taxpayers “to double taxation--a tax on taxes already paid to state and local governments,” New York Gov. Mario M. Cuomo asserted. He called Reagan’s overall plan “an insult to the fundamental principles of federalism.”

And Sen. Dave Durenberger (R-Minn.), a member of the Senate Finance Committee, argued that the deductions safeguard the ability of state and local governments to raise tax revenues.

“At a time when we are returning responsibilities from the federal level to the state and local levels, it makes little sense to deny those governments the revenues they need to pay for them,” Durenberger said.

Support From California Lawmakers

But Reagan received general support for his proposal from such key congressmen as Matsui and Rep. Fortney H. (Pete) Stark Jr. (D-Oakland), who also is a member of the Ways and Means panel.

Although one study has indicated that eliminating the deductions could add $1,100 to the average California family’s federal tax burden each year, Stark and Matsui said that the plan is essential to overall tax reform.

“If you restore the state and local deduction, tax reform is out the window,” Matsui said in an interview Wednesday. “Individual tax rates would go way up, and it would make it meaningless to do anything.”

However, he added that “modifications” might be necessary and that any revenue losses incurred from keeping part of the deductions should be recaptured by restricting tax preferences for businesses and investors.

Taxes Called Voluntary Costs

The Administration argues that elimination of the deductions is justified because state and local taxes are voluntary costs incurred by residents of each locality to provide services to themselves. By making these costs deductible, the argument goes, the current federal income tax law unfairly and inefficiently subsidizes those who voluntarily choose to provide themselves with more of these services.

Joseph J. Minarik, senior research associate with the Urban Institute in Washington, told Congress’ Joint Economic Committee that Reagan faces a political problem by retaining some tax breaks and discarding others in his plan.

He asked: “What is the answer to a middle-income homeowner who wonders why the oil and gas lobby got away essentially scot-free, while his state and local tax deductions were declared an egregious loophole?”