The Tax Impact

Why the Federal Tax Deduction for State Income Taxes Is an Unfair Handout to High-Tax States

By  | 

The IRS has created a monster with the federal tax deduction for state income taxes. This deduction creates a system in which states are encouraged to charge a higher income tax rate because their residents can pass off the cost to the rest of the country. Getting rid of this deduction would create a much fairer tax code and improve the nation’s economy.

How the State Income Tax Deduction Works

Taxpayers can claim the amount they pay in state income taxes as a deduction against their federal tax return. Every dollar you pay in state income taxes reduces your taxable income by a dollar. For example, if you’re in the 25 percent federal income tax bracket and pay $10,000 in state income taxes, this deduction would save you $2,500 in federal income taxes.

You can only claim the state income tax deduction if you itemize your federal deductions rather than taking the standard deduction, which is $6,300 for single taxpayers and $12,600 for married taxpayers. Itemizing only makes sense if all itemized deductions add up to more than the standard deduction.

Problems With This Deduction

This federal tax deduction causes some significant problems. First, it pushes a state’s income tax bill onto the federal government. If a taxpayer is in the 25 percent income tax bracket, for example, the federal government is essentially paying 25 percent of their state income tax bill through this deduction. As a result, states are encouraged to charge a higher income tax rate because the federal government picks up a large share of the residents’ tab. States that don’t charge high income taxes and have more reasonable budgets, on the other hand, have to help pay for their high-tax neighbors.

Another problem is that this tax deduction primarily benefits wealthy taxpayers. Most middle-class taxpayers get a better deal by taking the standard deduction, so they don’t receive any benefit from paying more in state income taxes. Wealthy taxpayers pay more in state income taxes and are in a higher tax bracket, giving them a disproportionately greater benefit from this tax break.

Benefits of Ending the Deduction

Eliminating this federal tax deduction would bring in a massive amount of extra revenue: Economists from the Heritage Foundation estimate that ending the deduction would bring in an extra $1.3 trillion dollars of federal tax revenue over the next 10 years. With this extra money, the federal government could lower its income tax rates—potentially by as much as 12.5 percent—while still bringing in the same amount of money.

Ending the subsidy for high state-income taxes would also push state governments toward more reasonable budgets. These states would be under pressure to tax and spend less because their residents would be obligated to pay the full bill.

While there are many problems in the federal tax code, the state income tax deduction is one of the worst. By getting rid of this unfair subsidy for high-tax states, the U.S. can take a big step toward a more productive economy.