Federal Tax Reform and the Deduction for State & Local Taxes
Abstract: Most proposals for federal tax reform envision the repeal of the deduction for state and local taxes (i.e, the SALT deduction). These proposals are not without precedent. The Reagan Administration’s proposed repeal of the SALT deduction as part of its 1985 tax reform proposal generated substantial academic analysis of this reform option. Since that time, however, there have been numerous developments relevant to the possibility of repeal or reform of the SALT deduction. The growing significance of the alternative minimum tax, the influence of the Great Recession on state and local fiscal structures, mounting concerns with subnational revenue volatility, and various demographic changes have altered the framework for considering the influence of federal tax reform on state and local fiscal incentives. We consider three specific reform options—the 2005 Presidential Advisory Panel on Federal Tax Reform, the Rivlin/Domenici plan, and the Simpson-Bowles National Commission on Fiscal Responsibility and Reform. Each of these proposals would repeal the SALT deduction in its entirety, yet the experience of TRA 1986 suggests that outright repeal is likely to face considerable political opposition from state and local government lobbyists. In an effort to anticipate the likely political instinct for reforms short of outright repeal, we also consider the merits of three alternative half-measures:(i) limiting the SALT deduction to a subset of taxpayers, (ii) limiting the SALT deduction to a subset of taxes, and (iii) converting the deduction to a flat-rate credit. Because of their differential effect on the tax price faced by state and local taxpayers, these reform options have very different implications for state and local fiscal incentives. These alternative reform options also implicate broader questions about the proper role of the federal government in the design of subnational tax structures.
