by Dr. Roy Cordato
Senior Economist, Emeritas
Should you be taxed on “income” that you are not allowed to take ownership of and not allowed to use for your own purposes? In other words, should you ever be taxed on “income” that never, in any meaningful sense, is yours?
This is the fundamental question facing Congress in deciding whether or not to eliminate the deductibility of state income and property taxes from federal taxable income, a proposal being supported by President Trump. Unfortunately, these questions are unlikely to become part of the debate over tax reform. Instead, the discussion has and will continue to focus on how those living in higher tax states “benefit more,” i.e., are penalized less, from the current system of state and local tax deductibility than those in low tax states. Those who point out this discrepancy often go on to claim that this justifies the elimination of this deduction because these differentials between states, based on their tax burdens, actually constitute a “subsidy” to those living in high tax states–i.e., New York, Connecticut, and California–by those living in lower tax states like North Carolina, Texas, and New Hampshire.
But to call this deduction a subsidy of one set of taxpayers by another is to put the cart before the horse. The first question that needs to be answered is, is it appropriate, from either an ethical or economic efficiency perspective, to tax the revenues used to pay state and local taxes in the first place? Just because under a particular tax regime some people are penalized less than others doesn’t mean that those who are penalized less are automatically subsidized by those who are penalized more. In a tax setting, to subsidize means either to directly take income from some and transfer it to others or to benefit some categories of taxpayers by allowing them to operate under a different set of rules than all other tax payers. The deductibility of property and sales taxes does not fit either of these categories.
So again, the question to consider is, should you be taxed on income that you are not allowed to take ownership of? As a question of morality, or what we might call tax fairness, it is difficult to see how the answer to this question could be yes. I don’t think that anyone would claim that it would be morally justified for an individual to be taxed on someone else’s income. This is exactly the case with income that goes to paying state income taxes and property taxes. This is income that we are forced to give up all rights to, with no enforceable promise of anything in return. Morally, as opposed to legally, this money is not actually realized as our own, i.e., we have no choice about how it is allocated. Therefore, to not allow state income taxes to be deductible from federal taxes is the moral equivalent of taxing people on someone else’s income. In this case, the state or local government’s.
But there is more than a moral principle at stake. Basic economic principles of taxation also suggest that state and local taxes should be deductible from taxable income at the federal level. It is widely recognized as a sound principle of tax analysis that only income used for consumption purposes should be taxed. This is the argument behind instituting a national sales tax in place of an income tax (note that under such a tax, state and local taxes would not be part of the taxable base) or instituting what is called a consumed income tax where any income that is not used for consumption purposes is deducted. This, theoretically, would be the functional equivalent of a sales tax. It is the model for state income tax reform that was endorsed by the John Locke Foundation in 2012.
From an economics perspective, taxes paid on income at one level of government, which is not consumption spending, should be deductible from income taxes paid at another level of government. The late Dr. Norman Ture’, a pioneer of supply-side tax analysis and widely considered to be the chief architect of the Economic Recovery Tax Act (ERTA), Ronald Reagan’s 1981 tax cut legislation, describes the economically proper tax base as follows:
An individual’s revenues from work, saving, and transfer payments received — would be taxable. Outflows associated with earning the revenues (such as net saving, investment, and some education outlays), and income transferred to others… would be deductible. Net taxable income would, in effect, consist of revenues utilized for the individual’s own consumption…People should be taxed only on the income over which they retain control and of which they enjoy the benefit. (Emphasis added.)
And to drive the point home Ture’ goes on to emphasize that taxation does not fit this category:
All payroll and state and local taxes would be deductible as income over which the taxpayer has lost control and transferred to others. State and local taxes are involuntary outflows.
The debate over whether state and local taxes should be deductible at the federal level largely missed the mark. Discussions guided by egalitarian considerations of whether those living in some states are “benefiting” more from this deduction than those living in other states fail to consider that, in a free society, an economically efficient and morally just tax base should not include income over which the taxpayer has lost all control and decision-making power. President Trump says it should. I hope that, like Ronald Reagan in 1981, Congress will take the advice of the late Norman Ture’ and recognize that the correct answer is a resounding no.