Federal Deductibility of State and Local Taxes

Prepared for Members and Committees of Congress

Under current law, taxpayers who itemize can deduct state and local real estate taxes, personal
property taxes, and income taxes from federal income when calculating taxable income. In
addition, a temporary deduction for sales taxes in lieu of income taxes expired December 31,
2007. The federal deduction for state and local taxes results in the federal government paying part
of these taxes through lower federal tax collections. Theory would suggest that taxpayers are
willing to accept higher state and local tax rates and greater state and local public spending
because of lower federal income taxes arising from the deduction. In addition, there is some
evidence that state and local governments rely more on these deductible taxes than on
nondeductible taxes and fees for services.
Repealing the deductibility of state and local taxes would affect state and local government fiscal
decisions, albeit indirectly. Generally, state and local public spending would decline, although the
magnitude of the decline is uncertain. And, repealing the deduction for state and local taxes
would shift the federal tax burden away from low-tax states to high-tax states. Maintaining the
current deductibility would continue the indirect federal subsidy for state/local spending.
Expanding deductibility, such as extending the sales tax deduction option or allowing non-
itemizers to deduct taxes pai