Why did the federal government ever allow taxpayers to deduct their state taxes from their federal taxes?

Question

At the end of 2017, President Trump signed into law the Tax Cuts and Jobs Act with among other things eliminated the federal tax deduction for state taxes paid.

Essentially, the federal government allowed taxpayers to remove whatever they already paid in state taxes, from their federal taxes owed.It is explained in this article.

My first question is, why did the federal government ever do this? Isn't this just another way of transferring money to states?

My second question is, under this regime, why would any state in their right mind not impose state taxes (9 states don't) ? Their residents aren't saving money anyways, as whatever they would have paid in state taxes goes to the federal government.

Answer 1

At the end of 2017, President Trump signed into law the Tax Cuts and Jobs Act with among other things eliminated the federal tax deduction for state taxes paid.

The state and local tax (SALT) deduction was not eliminated, it was capped ($10,000 for 2018). ~90% of the people that benefited from the deduction had income over $100k. So capping it limits benefits for people with higher incomes, and with the new standard deduction far fewer people will be itemizing deductions. It will hit high income earners in high-tax states the most. This cap is probably the most unpopular aspect of the new tax law.

Essentially, the federal government allowed taxpayers to remove whatever they already paid in state taxes, from their federal taxes owed.It is explained in this article.

This is a deduction, not a tax credit. Deductions reduce the amount of your income subjected to tax, but you're right that it does decrease federal tax revenue to some extent. Historically ~30% of people itemized deductions, itemized deductions are only beneficial to the extent that they exceed the standard deduction, so for a lot of people who itemized the actual impact of the SALT deduction was far less than their marginal tax rate applied to their SALT payments.

My first question is, why did the federal government ever do this? Isn't this just another way of transferring money to states?

The deduction helps limit double-taxation, that was probably the main motivation initially. Also, the people writing tax laws are elected officials who have incentive to keep their constituents happy.

My second question is, under this regime, why would any state in their right mind not impose state taxes (9 states don't) ? Their residents aren't saving money anyways, as whatever they would have paid in state taxes goes to the federal government.

The states that don't have state income tax still have taxes, they may have property tax, sales tax, ownership/use tax, gas tax, cigarette/vice taxes, etc. Those other types of tax typically fall into the SALT deduction. Typically states without income tax will have higher property tax rates or sales tax rates, so you have to compare full tax picture not just income tax.

Answer 2

The state tax deduction lets you deduct state taxes paid from your taxable income for calculating the federal tax that’s due, not from the federal tax paid. Suppose you pay state taxes of $2,000 and your marginal federal tax rate is 30% — your deduction from the amount paid in federal taxes is $600, not $2,000. The justification is that money paid in state taxes isn’t actually part of your income, so you shouldn’t be taxed as if it was.

Answer 3

You have many questions in this question; try to focus down to one question and it is more likely to be answered.

To address your question:

why would any state in their right mind not impose state taxes

Presumably you mean state income taxes. I live in Washington State, which has no state income tax. There are many ways to measure characteristics of tax systems on a spectrum; one is that a tax system is said to be "progressive" if the tax burden falls more on rich people, who can afford it, and "regressive" if the tax burden falls more on poor people, who cannot.

Due in large part to Washington State's lack of an income tax, we have the most regressive state taxation system in the United States. The 20 percent of families with the lowest incomes pay nearly 17 percent of their income on state and local taxes, while the 1 percent of families with the highest incomes paid only 2.4 percent of their incomes in state and local taxes.

You may wonder how state and local governments are funded at all; it is a combination of regressive sales taxes and property taxes that are legally prohibited from growing by more than 1% in nominal dollars. (Exercise: what is the effect of nominal revenues being prohibited from growing faster than the rate of inflation over time?)

As a result, Washington State is a "low tax, low service" state. Schools are underfunded to the point where the judiciary is holding the legislature in contempt because they have failed in their constitutional mandate to fund education.

Why, you ask, would any sane legislature not collect a state income tax in this situation? Well, it has come up for a vote eleven times in the past hundred years. Most recently, in 2010, a measure was put to the general population for a vote; the proposal would put a small state income tax on income in excess of $200000 per person or $400000 per couple. This measure was defeated by a 2-1 margin, and the vast majority of those voting against make nowhere even vaguely close to $200K a year.

Why would the residents of the state with the most regressive tax system in the country, where there are high sales and property taxes borne disproportionately by the poor, and deeply underfunded state services that poor and middle class people depend upon, vote 2-1 against a progressive tax on the wealthiest? There were two main arguments made by opponents. First, that an income tax would drive away jobs -- because of course, we all know how high-tax-high-service states like California and New York have no jobs, I guess?

But that wasn't the real argument against. The real argument against was "if you give the legislature an inch, they'll take a mile". A tiny income tax on high earners in Washington State will quickly become a high tax on everyone, so we cannot allow any tax increase whatsoever, the argument went. That argument was successful.

So, income taxes are a complete non-starter in Washington State; you ask how any state "in their right mind" could make this decision; I leave it to you to conclude whether or not Washington voters are in their right mind.

Answer 4

The original idea was this: The federal government taxes your income, but if you send your income on to somewhere else that is in the public interest, you wouldn't need to be taxed on that money, as you were already giving it to somewhere that benefited society. This was the thinking not only of the State and Local Tax deduction, but also of the Charitable Contribution deduction. State and local governments are tax-exempt organizations, as are charities, because the work that they do is considered a public benefit. In essence, you could funnel your income to those places instead of the federal government, and, ideally, the federal government wouldn't need as much money, because these organizations were doing some of the work that the federal government wouldn't have to do.

Unfortunately, because state and local taxes are not voluntary, this gives an incentive to those governments to tax as much as possible. Among other reasons, the new limit is an attempt to even the playing field between high-tax and low-tax states, so that the federal government does not lose so much money to the high-tax states at the expense of the low-tax states.

Answer 5

My first question is, why did the federal government ever do this? Isn't this just another way of transferring money to states?

There's also a purely mathematical reason for the federal govt to allow deduction of state and local taxes (ESPECIALLY SALT income taxes) from your federal tax income: in theory if tax rates were high enough, and no SALT deduction was allowed, you could end up owing more in taxes than dollars earned.

For example, say your state had a super high tax bracket of 40%. And let's imagine federal income taxes were closer to the levels seen in the 1950s-1960s USA, where the top marginal rates were 70-90%. If you paid 40% on SALT taxes, but couldn't deduct them, then you paid an additional 70% on federal taxes, you'd end owing 110% of your income!! (at least income in the higher brackets).

The US Bill of Rights (especially the 10th amendment) was designed to give significant power to the states rather than the federal govt., so giving states the power to levy their own taxes without having to worry about double taxation on every dollar was an attractive feature.

Answer 6

I'm writing this answer to try and cover the question "why did the federal government ever do this [allow deductions of certain state taxes]?"

Simply put, the IRS's taxes on income are (were) intended to tax actual income received, which might be less than the theoretical amount earned. State income taxes are money that is never actually seen by the tax payer, if someone earns $50,000 and their state takes 5% of that they will never see or receive that $2,500. It seems reasonable that earnings which someone would never receive are not taxed.

For a good example of why this made sense, compare this to "theft and casualty losses". If someone earns $50,000 but is then robbed of all but $5,000, they do not have to pay taxes on all $50,000. In fact they would probably not even have enough money to pay the taxes on the full $50,000 if it was demanded of them.

Another more tenuous analogy would be the deduction on IRA contributions. Money one places in an IRA they are not actually earning as income, they cannot do anything with it or use it (without penalties). Instead the money is taxed in retirement when the person actually receives the money (in a form they can spend and use). Again, this taxes income one actually sees and has access to.

This follows the same principle of income taxes normally being based on the money you in some sense actually get.

No longer allowing an unlimited state tax deduction in a sense changes this principle and allows money the tax payer never got to be taxed again. I shaln't go into who this may benefit or hurt but in essence that is the difference.

Answer 7

My second question is, under this regime, why would any state in their right mind not impose state taxes (9 states don't) ? Their residents aren't saving money anyways, as whatever they would have paid in state taxes goes to the federal government.

This is not true.

1. Not everyone could deduct state and local taxes (SALT) on their federal income tax under the old system, only people who itemize. Since most people don't itemize, they get zero deduction from SALT. It is probable that fewer will itemize under the new system, but under the old system only about 30% did.
2. Even among people who did itemize, it did not reduce their federal taxes by the amount of the SALT. First, it's a deduction in the taxable income, not the taxes. Second, part of that is lost to itemization for most people.

Consider a simplified federal system (old). The standard deduction is $5000 (perhaps this was a while ago). The tax rate is 20% (for simple arithmetic). You paid $4000 in mortgage interest and $4000 in SALT. No other itemized deductions.

If you don't itemize, you take the $5000 deduction, reducing your taxes by $1000 (20% of $5000). If you do itemize, you take an $8000 deduction, reducing your taxes by $1600 (20% of $5000). So for a $4000 payment of SALT, you save $600. That's only 15% of the SALT you paid. You still had to pay the other 85%.

It gets worse. What if you didn't have the $4000 in mortgage interest? Then you take the standard deduction. You get 0% savings from your SALT "deduction" that you couldn't take.

Now, let's look at someone with a higher tax rate, say 40% (because 39.6% is too much arithmetic). That person may have no mortgage, but pay $40,000 in SALT. That's well over the $5000 standard deduction. So that person saves $16,000 in SALT deduction (40% of $40,000). That's $14,000 more than the $2000 from the standard deduction (40% of $5000).

Now, go back earlier in the history of the SALT deduction. Tax rates are up to 94%. The rich person can deduct almost all the SALT paid. Most people can't. And those that can, are only paying a small amount of tax anyway. They get little benefit from the deduction (still $600 if their tax rate and standard deduction are the same).

And that's why SALT was deductible. It was a big assist to rich people at a modest cost for middle class people. Poor people get no help at all. Since politicians have a lot of reasons to make rich people happy, it's unsurprising that tax policy was often made to help them. Especially when it also helps other politicians (those in state and local government).

You might think that capping the SALT and mortgage interest deductions fixes this. But it doesn't. Rich people can easily afford a mortgage on a $500,000 house and generate more than $10,000 in SALT. But middle class people often can't. Remember that in our example, the deductions were $4000 and $4000. So the middle class gets only part of the benefit while rich people get the full amount.

On the bright side, very few middle class people will take the $10,000 SALT deduction rather than the $12,000 standard deduction. It really only makes sense in the first few years of a mortgage. And it may not then, as many won't use close to the cap. Hopefully this will cause support for this regressive deduction to erode.

Answer 8

Double taxation of income is viewed as immoral. Imagine you earn 1$, and 3 different levels of government apply a 40% income tax on it.

All together you owe 1.2$ for every 1$ you earn. Earn 100,000$, owe the government 120,000$.

If you avoid double taxation, the 0.4$ you send to level of goverment 1 reduces your taxible income to 0.6$. Then you owe 0.24$ to goverment 2, leaving you with 0.36$. Then you owe 0.144$ to level of goverment 3, leaving you with 0.216$.

Still expensive/bad, but not ridiculous.

Taxing income on income not recieved warps incentives. This is why you can deduce the cost of earning your income as a general rule.

State taxes are a cost of living in a state, and hence a cost of earning the income in that state. So you can deduct it from your income.

It does not permit you to deduct it from your taxes. So paying 40$ in state taxes does not reduce your federal taxes by 40$. If your marginal federal tax rate is 20$, then it reduces your federal taxes by 8$.

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As for why state income tax, or why not; income tax permits both progressive taxation (taxing people earning more money more than people earning less), and it tends to be taxation that is hard to avoid and relatively easy to assess and collect.

Now, on the other hand, sales tax acts like a tarrif.

Suppose you have two states. In state 1 you have a 20% flat income tax; in state 2, a 25% sales tax.

Suppose you have a widget that costs 100$ in labour, before taxes.

In state 1 to pay your employees (or yourself) 100$ you need to spend 125$. 25$ goes to the state, 100$ to the employee. So you sell the widget for 125$.

In state 2 you pay your employees 100$ for them to get 100$. When you sell the widget, you have to sell it for 125$, and the state gets 25$.

So far so good.

Now what happens when you produce your widget in state 2 and sell it in state 1?

You pay employees 100$. They get 100$. You ship to state 1. You sell it for 100$, 25$ cheaper than local producers can.

How about make it in state 1 and sell it in state 2?

You pay employees 100$ after tax, which costs 125$. You ship to state 2. You sell for 125*1.25=156.25$. 25% more.

If state 2 had an income tax like state 1, but subsidized all exports by 20% and had a tarrif on all imports of 25%, the math would be the same.

Thus, having your government tax base be sales taxes instead of income tax act like tarrif barrier.

The downsides -- harder to tax, easier to cheat, massively regressive that loads taxes on poorer people -- remain. But the ability to effectively place tarrifs and subsidies on imports and exports make it very tempting.