As President Bush lays the groundwork for a possible overhaul of the U.S. tax code, one option under consideration would deal its biggest financial blow to citizens of blue states such as California and New York.
Some conservative activists are urging the Bush administration to scrap the federal deduction for state and local taxes as part of a broader plan to revamp the nation’s tax system.
Although the proposal would hurt some taxpayers in nearly every state, it would hit hardest in states with higher-than-average income levels and bigger-than-average state and local tax burdens. High on the list are a number of blue states -- those that were carried by Democrat Sen. John F. Kerry in last month’s presidential election.
Taxpayers in California and New York, for example, which have top state income tax rates of 9.3% and 6.5% respectively, would be highly affected; residents of Florida and Texas, which have no state income taxes, much less so.
“There’s no question this effort would punish blue states,” said Rep. Robert T. Matsui (D-Sacramento), a member of the tax-writing House Ways and Means Committee. Over time, he said, it could force state and local governments to cut expenditures.
That could happen if taxpayers, stung by the higher tax burden that would come from losing the deduction for state and local tax payments, demand a cut in local and state tax rates and become unwilling to approve any increases.
Supporters of the change insist the disproportionate effect on blue states is a coincidence, but they acknowledge that the proposal could hurt most in states that voted against Bush.
“Let me put it like this: It certainly isn’t something that’s a discouragement,” said one prominent conservative. “Yes, we talked about this. The fact that it hits blue states is not something that’s been missed among Republicans.”
But in a political complication, some blue states that would be hit hardest by the tax change are led by Republicans. If the White House adopts the proposal, it could create a rift with some of the GOP’s biggest stars in those states, such as Gov. Arnold Schwarzenegger and New York Gov. George E. Pataki, among others.
Schwarzenegger’s office declined to comment on the proposal. But California State Controller Steve Westly, a Democrat, said it would amount to a hidden tax increase for millions of California taxpayers, who already pay $58 billion a year more to the federal government than they get back in services.
“Simply put, it would be yet another poke in the eye from the federal government to California,” said Westly.
It remains unclear whether the administration will adopt the proposal. Some administration and congressional advisors said they believed the idea had been floated as a trial balloon to see how much support or opposition it attracted.
If the administration did move to eliminate the deduction, it might partially offset the costs to blue state residents by adding other elements to the tax package, such as a reduction of top tax rates or a repeal of the increasingly broad Alternative Minimum Tax, which also hits blue states hard.
Bush has said one of his top second-term priorities is to revamp the tax code so that it is simpler, fairer and more pro-growth. He also has said he would be guided by the recommendations of a bipartisan commission he planned to appoint by the end of the year.
White House and Treasury officials say all overhaul options are on the table. “The president has yet to even name the advisory panel, so we’re not going to rule things in or out at this point,” said White House spokeswoman Claire Buchan.
Bush has hinted strongly that his proposal would preserve two popular tax breaks: the deductions for mortgage interest and charitable contributions. That he has not mentioned preserving the state and local tax deduction has been interpreted by some as a signal that it is fair game as the administration looks for ways to finance other tax changes.
“This is very real,” said one congressional staffer close to the tax discussion. “They need the money desperately.... It’s one of the only things they can attempt to do to finance tax reform.”
The deduction for state and local taxes is one of the biggest tax breaks claimed by households. This year, the deduction is valued at $46 billion. That compares with $70 billion for the mortgage interest deduction and $30 billion for charitable contribution deductions, according to the Office of Management and Budget.
“The people who are going to be disproportionately penalized by this are high-income households, especially those in states with relatively high or progressive income taxes,” said Kim Rueben, a research fellow at the Public Policy Institute of California.
Last year, 5.5 million California households, or 37% of all tax filers in the state, claimed deductions for state and local income taxes. In New York, 3.2 million households, or 37%, did.
Supporters of the deduction say people should not be required to pay a federal tax on taxes paid to state and local governments. The counterargument is that income used to pay for state and local government services is no different than income used to acquire anything else, and should be taxed the same.
In addition, some overhaul advocates say citizens in low tax states end up unfairly subsidizing services in high tax states because of revenue lost to the deduction.
Scrapping the deduction would provide a financial windfall that could pay for other tax cuts and proposals sought by the administration. Near the top of the list would be the elimination, or a scaling back, of the Alternative Minimum Tax, according to overhaul advocates.
The AMT was created in 1969 to make sure wealthy Americans could not avoid taxation because they were able to claim big deductions. But the AMT is not indexed for inflation, and more and more middle-class Americans are falling within its grasp. About 2% of tax filers were subject to the AMT in 2001; the figure is expected to rise to 20% by 2010.
Len Burman, codirector of the nonpartisan Tax Policy Center, estimates that eliminating the state and local tax deduction would generate enough additional revenue over 10 years to pay for repeal of the AMT and finance $335 billion in additional tax cuts or deficit reduction.
Tax attorney Pamela F. Olson, who was assistant Treasury secretary for tax policy before leaving the administration this year, said the political appeal of slaying or taming the AMT might help overcome opposition to removing the deduction for state and local taxes.
“If you’re going to try to fix the AMT, you’re going to have to do something with the state and local tax deduction if you don’t want a big revenue loss,” said economist Kevin A. Hassett at the conservative American Enterprise Institute. “If you do nothing, if you just sit back and have gridlock, then those states are really going to get hammered, because everybody in New York will be on the AMT sooner than people from Wyoming.”
This would not be the first attempt to get rid of the state and local tax deduction. It was targeted for elimination nearly two decades ago as part of a sweeping Reagan administration tax overhaul enacted in 1986.
But the tax break was spared following a lobbying campaign by officials from New York and other high tax states.
“Mario Cuomo practically lived in Washington for a couple of months fighting to keep that deduction,” economist Bruce Bartlett, a former Treasury Department official, said of the then-governor of New York. “Eventually the Reagan people backed down. It’s pretty tough to do. It’s one of the biggest deductions most people have on their tax returns.”
Economist Max B. Sawicky at the liberal Economic Policy Institute said the deduction allowed states to have higher income taxes and offer more state services. If the federal tax break were eliminated, he said, it would create political pressure to reduce state taxes.
“What do you do in California, where you have that absurd budget deficit? It becomes quite a problem for Gov. Schwarzenegger, who was important in getting the president reelected,” Sawicky said. “Gov. Pataki, too. It puts them in a bit of a bind.” In Sacramento, Schwarzenegger spokeswoman Ashley Snee declined to comment on the possibility the deduction could be targeted for elimination.
“If the administration puts forth a tax reform proposal, we will take a look at it to determine its impact on California,” Snee said. “But we haven’t taken a position on this idea at this point.”
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A valued deduction
A proposal to eliminate the deduction for local and state taxes on federal tax returns would affect blue states more than it would red states. In 2002, two-thirds of the $184 billion claimed under the deduction was in states carried by Sen. John F. Kerry. About a third of the total was in just two states, New York and California.
North Carolina: 6,163
South Carolina: 2,332
Alabama : 1,608
New Mexico: 836
West Virginia: 595
North Dakota: 127
South Dakota*: 28
New York: 24,744
New Jersey: 8,609
Michigan : 5,775
Hawaii : 869
District of Columbia: 868
Rhode Island : 833
Vermont : 348
New Hampshire** : 345
Blue, red division
How state and local tax deductions divide among Bush and Kerry states:
(Amounts claimed under the deduction in hundreds of thousands rounded:)
* No state income tax
** State income taxes are limited to dividend and interest income only.
Source: Internal Revenue Service