Why It Makes Sense that State and Local Taxes Are Deductible

This article first appeared on the American Enterprise Institute site.

Republicans have proposed eliminating the deductibility of state and local taxes (SALT) for federal income tax purposes.

In their portrayal, the deduction is just another loophole in the tax code — a way for taxpayers to avoid handing to the IRS what is rightfully the IRS's — a distortion that keeps us from having the beautiful system of a broad base and low rates that we all want.

This is incorrect in that unlike getting rid of distortionary features of the tax code like the exclusion of employer-provided health insurance or the mortgage interest deduction, eliminating the SALT deduction raises marginal tax rates directly.

It does so in particular, unfortunately, for the most productive workers in the most productive parts of the country.

Even if the top marginal rate for the federal income tax rate were to go down to 35 percent, the effective top marginal tax rate in Silicon Valley, for example, would go from 47.6 percent to 48.3 percent. Without the cut in the top rate, that number would be over 52 percent. In addition, the SALT deduction helps avoid double taxation of the same income.

But the distinction is more profound.

The SALT deduction, which dates all the way back to the introduction of the federal income tax, is a lynchpin of the federalist system.

Joann McNeill, a postal worker at the James A. Farley post office, places cancellation stamps on envelopes bound for the IRS as last-minute tax filers get their returns in the mail just in time as the midnight deadline for filing taxes nears April 15, 2005 in New York City. Monika Graff/Getty

Just like the charitable deduction expresses our preference, as a society, for civil-society solutions over solutions implemented in the shadow of the government's monopoly on violence, the SALT deduction expresses our preference for local solutions to local problems.

As Tocqueville wrote about the townships of New England: "They did not receive their powers from the central authority, but, on the contrary, they gave up a portion of their independence to the state."

State and local taxing power should precede federal taxing power; and, logically, state and local taxes paid should thus be excluded from the federal tax base. The central, federal authority should play a subsidiary role in our society, only to be activated when local communities cannot solve their collective-action problems independently.

Our tax code should reflect this idea both as an expression of our values, and to ensure that local governments do not see their ability to raise revenue crowded out by federal legislators.

On the other hand, the SALT deduction incentivizes higher state and local spending and doesn't have the great distributional implications, as my colleague Alex Brill carefully explains here.

I could probably go either way on this one.

Stan Veuger is a resident scholar at the American Enterprise Institute (AEI).