High-Tax States Stand to Lose From Reform

President Reagan calls his tax reform plan a “new American Revolution,” but to Wisconsin Gov. Anthony S. Earl, it is more like “a new Civil War--only this time the fix is in and the South wins.”

What has upset Earl and many other state and local leaders is Reagan’s proposal to eliminate the federal deduction for state and local taxes. In their view, that step would hit particularly hard at the nation’s predominantly Northern high-tax states.

An examination of the likely impact of Reagan’s plan on the nation’s high-tax states, a category that includes California, shows that they do indeed stand to lose--in two major ways--from the repeal of the deduction for state and local taxes.

Significant Deductions

Most obviously, their individual taxpayers would give up one of their most popular and significant tax deductions. Although many taxpayers even in high-tax states would probably enjoy a tax cut as a result of the total effect of the Reagan plan, the winners would still fare less well than comparable taxpayers where state and local taxes are low.

In Milwaukee, a high-tax city in a high-tax state, a typical family of four with income of $30,000 would lose a substantial state and local tax deduction and suffer a $335 federal tax increase. An identical family living in New Orleans, where both city and state taxes are far lower, would enjoy a $113 federal tax cut.

And beyond the impact on individuals, the Reagan plan would make it politically more difficult for states to sustain high tax rates or to raise taxes so that they could maintain present services or offer new ones. No longer would higher state taxes be partly offset by a greater federal tax deduction.

To Earl, that flies in the face of Reagan’s policy of returning governmental authority from Washington to the states. “How can we carry our burden of responsibility if we are going to be penalized?” he asked.

Earl’s allies include some of the nation’s biggest states; the National League of Cities says that, except for California, the 10 states that have gained the most from the state and local tax deduction are in the populous Northeast and Great Lakes regions. Their criticism makes the proposed repeal of the state and local tax deduction the most vulnerable piece of Reagan’s complex tax package.

But it is also a pivotal component, the single largest revenue raiser of all of Reagan’s proposals to abolish a host of individual and corporate tax breaks. In 1987, when it would become fully effective, it would recapture $33 billion of the $50 billion that would be lost from the package’s most politically appealing proposal, a drastic reduction in individual tax rates.

Compromise Proposals

If the state and local tax deduction remained intact, rate reduction would become nearly impossible. So a successful campaign by state officials such as Earl could bring Reagan’s entire package crashing down.

Although the Treasury Department has been looking at proposals to compromise by limiting the state and local tax deduction instead of abolishing it, Reagan has so far insisted that his position is non-negotiable. And his White House communications director, Patrick J. Buchanan, has exchanged bitter charges over the issue with New York Gov. Mario M. Cuomo, who has led the protests of Northeastern and Midwestern public officials.

When Cuomo and other New York officials complained about the potential impact of Reagan’s tax package on them, Buchanan labeled their protest “neo-Socialist.” Cuomo called Buchanan’s remarks “stunningly irresponsible,” and Buchanan responded by calling the Democratic governor a “glib, fast-talking lobbyist for a reactionary liberalism.”

Value of Deduction

In New York, the highest-tax state of all, the state and local tax deduction was worth $233 per capita in 1982, according to the federal Advisory Commission on Intergovernmental Relations. The deduction was worth $155 per capita in California and $137 here in Wisconsin, two moderately high-tax states.

But in low-tax Southern states, the deduction benefited taxpayers far less: only $31 per capita, for example, in Louisiana, a state that relies heavily on energy taxes for its revenue.

Competitive Disadvantage

Earl argues that repealing the state and local tax deduction would exaggerate the competitive disadvantage of the high-tax states of the Northeast and Midwest in attracting new companies and jobs. Other things being equal, he fears, corporations would locate in places where their own taxes are low--and that, more than ever, would mean the already prospering Sun Belt states.

The Administration asserts that the state and local tax deduction, which has been in law ever since there was a tax code, is enjoyed mostly by rich taxpayers who itemize their deductions.

But Internal Revenue Service statistics show that more than the rich benefit from the state and local tax deduction. More than 40% of taxpayers nationwide took the state and local tax deduction in 1982 because they itemized their deductions. And in 1983, according to the IRS, 78% of taxpayers with adjusted gross incomes of $30,000 to $40,000--the range that includes the national median family income--itemized their deductions.

A chief architect of the Reagan tax plan, Deputy Assistant Treasury Secretary Charles E. McClure Jr., maintains that state and local taxes represent payments for services such as state highways and local schools. So the state and local tax deduction, he says, amounts to a federal subsidy for consumers of these services who are sufficiently well-off to itemize their federal tax deductions.

For the sake of argument, he assumes that California taxpayers pay $1,000 a year in state and local taxes to finance basic services. In Watts, most taxpayers do not itemize and get no federal tax break for their theoretical $1,000 in state and local tax payments.

But in Beverly Hills, where most taxpayers itemize their deductions and are in the top 50% tax bracket, the federal tax deduction for state and local taxes means a $500 federal tax savings, McClure says, reducing the cost of public services to $500.

“Why should Beverly Hills or Los Altos get a high federal subsidy for services,” he asked, “when Oakland or Watts gets nothing?”

Some economists dispute McClure’s argument that state and local taxes represent payments for public services.

“State and local taxes are a forced reduction in personal income, very often not tied to public service benefits,” Rutgers University economist Henry J. Raimondi said at a recent congressional hearing. Wealthy taxpayers without children, for example, are not consumers of public education or welfare benefits.

‘You’d Pay Tax on a Tax’

On Saturday, Rep. Mary Rose Oakar of Ohio, giving the official Democratic response to Reagan’s weekly radio address, quoted Reagan as saying two years ago that any plan to eliminate federal tax deductions for state and local taxes would mean that “you’d pay tax on a tax.”

“He was right then,” she said. “Let’s hold him to his word now.”

Here in Wisconsin, Reagan’s proposal to do away with the state and local tax deduction is viewed less as an effort to simplify the tax code than as another salvo in Reagan’s war against government spending. “It’s his way to export his small-government notions a step further, from the national government to the states,” Earl said.

Earl’s chief aide, Hal Bergan, said Reagan accomplished the same thing at the federal level with his 1981 tax cut, which put pressure on Congress to enact compensating spending cuts.

“If you turn off all the spigots, eventually government will spend less and get smaller,” Bergan said. “But if the goal is lower spending for all states, then you’ll turn all states into Mississippi,” which has a reputation for low-quality public services.

Joseph J. Minarik of Washington’s Urban Institute said the Administration “has been trying energetically to devolve public responsibility from the federal government to the states, saying that this is the proper place for these services to be provided and paid for. Now to turn around and take away the deduction, to limit the states’ ability to raise the money, amounts to a double whammy. What it really means is that they want the states to do less.”

Wisconsin Legacy

The Advisory Commission on Intergovernmental Relations says the tax deduction has indeed encouraged state and local governments in Wisconsin and elsewhere to tax more--and spend more. The commission estimates that, in 1984, when the deduction cost the federal government about $30 billion in tax revenue, state and local governments raised and spent $11 billion more than they would have if the deduction had not shielded their residents from some federal tax payments.

Cutting back would run against the grain here in Wisconsin, where the state income tax, instituted in 1911, predates the federal income tax by two years. Wisconsin officials see the legacy of good roads, a clean environment, a top-flight state university system and extensive state aid to cities and towns as the prerogative of their citizens to enjoy--and pay for.

“States are democracies too, and in many of them their citizens want better services and more spending on schools and higher education,” said Michael Ley, the Wisconsin secretary of revenue. “If the people want a higher quality of service, who is the President or the Congress to step in and say they can’t have it? We see it as an intrusion on state authority.”

The Administration responds that nobody in Washington is urging Wisconsin to cut its taxes. But if the voters want to maintain their high-quality public services, the federal tax system should not subsidize them.

Treasury’s McClure denied any “ideological bias against government spending.” The tax proposal, he said, would merely remove the state and local tax deduction’s “bias” in favor of public spending.

REAGAN TAX PLAN’S VARIABLE IMPACT Eliminating the Deduction for State and Local Taxes

The Times computed the 1986 federal tax under current law and under President Reagan’s tax reform proposal for identical families in Milwaukee, a city where residents have a high state and local tax burden, and New Orleans, where both state and local taxes are comparatively low.

Each family is assumed to have two earners and two children, and each takes itemized deductions typical of families at its income level. Computation was made from data supplied by the Treasury Department and the Advisory Commission on Intergovernmental Relations.

Milwaukee

Family income $30,000 $60,000 $120,000 State and local taxes 3,114 7,569 14,870 Federal taxes, current law 1,945 6,755 22,398 Federal taxes, Reagan plan 2,280 7,605 21,595 Change in federal taxes +335 +850 -803 Percent change +17.2% +12.6% -3.6%

New Orleans

Family income $30,000 $60,000 $120,000 State and local taxes 626 1,268 3,166 Federal taxes, current law 2,393 8,825 25,912 Federal taxes, Reagan plan 2,280 7,605 21,595 Change in federal taxes -113 -1,220 -4,317 Percent change -4.7% -13.8% -16.7%