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Assessing the Federal Deduction for State and Local Tax Payments

  • Gilbert E. Metcalf

Federal deductibility for state and local taxes constitutes one of the largest tax expenditures in the federal budget and provides a significant source of federal support to state and local governments. Deductibility was restricted in the Tax Reform Act of 1986 by removing the deduction for general sales taxes. More recently the President's Advisory Panel on Federal Tax Reform recommended eliminating the deduction altogether as one of several revenue-raising initiatives to finance comprehensive tax reform. I carry out a number of distributional analyses - considering both variation across income and across states - of the subsidy from deductibility as well as the distributional impact of potential partial reforms. In addition, I consider three counterfactuals for 2004 - a tax system without the Bush tax cuts for 2001 and 2003, a tax system without the 2004 AMT patch, and a tax system without the AMT - to see how the benefits of deductibility are affected by these changes in the tax law. Next I consider how behavioral responses affect the tax expenditure estimates. Feldstein and Metcalf (1987) argued that tax expenditures overestimate the revenue gain from eliminating deductibility as they do not take into account a likely shift away from once-deductible taxes to non-deductible taxes and fees in the absence of deductibility. Many of these latter taxes and fees are paid by businesses. As business costs rise, federal business tax collections would fall, offsetting some of the gains of ending deductibility. Feldstein and Metcalf also found that ending deductibility would have little if any impact on state and local spending itself. Using a large panel of data on state and local governments, I revisit this issue and find that the Feldstein-Metcalf results are robust to adding more years of analysis.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14023.

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Date of creation: May 2008
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Publication status: published as Metcalf, Gilbert E., 2011. "Assessing The Federal Deduction For State And Local Tax Payments," National Tax Journal, National Tax Association, vol. 64(2), pages 565-90, June Cita.
Handle: RePEc:nbr:nberwo:14023
Note: PE
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  1. Saez, Emmanuel, 2004. "Direct or indirect tax instruments for redistribution: short-run versus long-run," Journal of Public Economics, Elsevier, vol. 88(3-4), pages 503-518, March.
  2. Feldstein, Martin S & Metcalf, Gilbert E, 1987. "The Effect of Federal Tax Deductibility on State and Local Taxes and Spending," Journal of Political Economy, University of Chicago Press, vol. 95(4), pages 710-36, August.
  3. Stiglitz, Joseph E., 1982. "Self-selection and Pareto efficient taxation," Journal of Public Economics, Elsevier, vol. 17(2), pages 213-240, March.
  4. Metcalf, Gilbert E., 1992. "Deductibility and optimal state and local fiscal policy," Economics Letters, Elsevier, vol. 39(2), pages 217-221, June.
  5. Harvey S. Rosen, 1988. "Fiscal Federalism: Quantitative Studies," NBER Books, National Bureau of Economic Research, Inc, number rose88-1, June.
  6. Naito, Hisahiro, 1999. "Re-examination of uniform commodity taxes under a non-linear income tax system and its implication for production efficiency," Journal of Public Economics, Elsevier, vol. 71(2), pages 165-188, February.
  7. Harvey S. Rosen, 1988. "Introduction to "Fiscal Federalism: Quantitative Studies"," NBER Chapters, in: Fiscal Federalism: Quantitative Studies, pages 1-4 National Bureau of Economic Research, Inc.
  8. Hettich, Walter & Winer, Stanley, 1984. "A positive model of tax structure," Journal of Public Economics, Elsevier, vol. 24(1), pages 67-87, June.
  9. Chernick, Howard, 2005. "On the Determinants of Subnational Tax Progressivity in the U.S," National Tax Journal, National Tax Association, vol. 58(1), pages 93-112, March.
  10. Daniel Feenberg & Elisabeth Coutts, 1993. "An introduction to the TAXSIM model," Journal of Policy Analysis and Management, John Wiley & Sons, Ltd., vol. 12(1), pages 189-194.
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