A couple week ago I argued in this Carolina Journal Daily Journal that it is bad tax policy for the federal government to eliminate the deduction for state and local taxes. I won’t repeat those arguments in this blog post, but generally I argued that it is illegitimate, from both an economics and moral perspective, to include in the tax base revenues that the taxpayer never has control over and is forced to transfer to another someone else.
But, in addition to the arguments I previously made there are two others that could be considered equally important that have gone unrecognized by the advocates of this effort to broaden the tax base.
First, the inclusion of income used to pay state and local taxes in the tax base has nothing to do with the overarching purpose of the tax reform, which is to stimulate the economy and enhance economic growth. The focus of all other aspects of the tax reform effort has been on reducing penalties in the tax code against saving and investment relative to consumption and work effort relative to leisure. In other words to encourage economic growth and job creation. The first is being addressed with proposals to dramatically cut the corporate income tax, eliminate the estate (death) tax, and institute a system of expensing, as opposed to depreciation, for purchases of physical capital. The second is being addressed with proposals to reduce the number of tax brackets from 7 to 3 and to reduce the rates. This allows people to keep more of each additional dollar they earn, which encourages both additional work effort and the acquisition of human capital. The fact is that whether or not the base includes a deduction for state and local taxes is actually irrelevant to the economic growth effects of the reform.
Some would dispute this, arguing that by broadening the base in this way tax rates could be lower, which would have a positive effect on economic growth. But this is a short sighted and maybe even naive argument, which takes me to my second point. Namely that this move to broaden the base could actually lead to higher taxes and bigger government.
It is true that in a revenue neutral environment, if the tax base is broader, for any reason, rates can be lower. But that is quite different than arguing that they will be lower. The fact is that, over the long run the government has a voracious appetite for new revenues and a broader tax base makes that appetite easier to satisfy, to the extent that it can be satisfied. If one is myopically focused on the current negotiations over reform, this effort to broaden the base may very well be part of a tradeoff for lower rates. But looking past the politics of the moment this base broadening will encourage the growth of the federal government and actually make it easier to increase rates and revenues.
The reason is that it is much easier to raise additional revenues by raising rates when the base is broader than when it is narrower. Given a broader tax base, a much smaller increase in rates will bring forth a larger increase in revenues. Smaller rate increases, particularly if applied to higher income individuals, will be politically easier to sell than the larger ones that would be required if the base were narrower, i.e., if income used to pay state and local taxes remained out of reach to the IRS.
Furthermore, with a larger tax base, the costs of a given rate increase will be spread more widely and the burden for any individual taxpayer will be smaller while, almost certainly the benefits of the tax increase (the spending) will be concentrated on more easily identifiable groups. This sets in motions the classic public choice analysis where special interest lobbyists will bring a great deal of support for the tax increase and the taxpayers, who individually will suffer very little, will have no incentive to oppose them.
The bottom line is that this change in the tax deductibility of state and local taxes increases the government’s control over a greater portion of our income. How this could be appealing to libertarians and small government conservatives is something I find difficult to comprehend.
