Prepare to Fight for Itemized Deductions

State and local taxes deserve higher priority than mortgage interest.
by | May 12, 2011

The two national political parties have begun to draw battle lines over how to reduce the federal budget deficit. President Obama and Congressional Democrats continue to argue that part of the long-term solution must include tax increases for the wealthiest Americans. Republicans continue to oppose any form of tax increases at any level, and suggest that austerity should be limited primarily to spending cuts. Meanwhile, the president's bipartisan commission on fiscal reforms suggests that tax expenditures, itemized deductions and other loopholes be closed to permit a reduction in marginal tax rates.

Looking downfield, I can't help but wonder if there won't be a grand compromise that entails a cap of some kind on itemized deductions. The political premise would be that upper-income taxpayers are now receiving the lion's share of these tax benefits, and they are the ones most able to pay extra taxes to help balance the budget. So if the House won't raise their tax rates, why not just put a cap on the amount millionaires can deduct?

State and local officials have a vested interest in federal tax-deduction policies for two reasons. First, a number of states piggy-back their definitions of taxable income on the federal tax code, so a cap on deductions would increase the state income tax base for several states. That would actually produce more state income tax revenue than an increase in federal tax rates. Second, and also importantly, the way Congress caps itemized deductions could impact state and local tax policies -- and local politics.

To see how this works, let's suppose that Congress decided next year to put a cap on itemized deductions of all kinds, maybe at the level of $100,000. Affluent taxpayers in some states often deduct this much for their state income taxes, local property taxes and mortgage interest. If federal tax policy limits their deductions to a fixed number or a percentage of income, then states with high income tax rates and local governments with high property tax rates would face increased voter resistance from high-income taxpayers who could no longer deduct some of these taxes on their federal returns. The net tax cost of "excessive" state and local taxes would then increase by 35 percent for those taxpayers.

Also of importance to local governments is the impact that a cap on deductions would have on house prices and thus, property tax revenues. If mortgage interest deductions are capped, then the costs of homeownership will increase and will dampen housing prices in a residential market that is still anemic. Property tax revenues will thus be impaired if the mortgage deduction is eliminated. Needless to say, the realtor and homebuilders lobbyists will be sure to let Congress know that's a hot potato.

As for intergovernmental equity, what's lost in these discussions is the taxpayer's ability to make individual choices. The classic textbook on public finance, Public Finance in Theory and Practice, by Richard and Peggy Musgrave separated "intergovernmental tax equity" from "tax expenditures," and that's a helpful distinction. The residents of New York City or San Francisco cannot evade high state and local taxes without relocating -- and disrupting the local labor markets and other factors -- so it is appropriate from an intergovernmental tax equity standpoint that federal tax policy allow such taxes to be deducted from the federal base income. This is different from home mortgage interest, especially for second homes, which is a discretionary decision, especially at higher levels. The mortgage interest deduction is a tax expenditure. Therefore, some will argue that a starting place to curb tax expenditures would be to cap the amount of mortgage interest deductible to some level below current limits of $1 million per household, perhaps over a phase-down period. (Other candidates for tax-expenditure reduction would be the deductions allowed for health benefits, which caused a huge stir during the debates over health-care reform.)

There is a partisan angle to this discussion. High income-tax states such as California, Hawaii, New York and Oregon tend to be "blue states" with higher percentages of Democratic voters. Thus, an across-the-board cap on itemized deductions would tend to penalize those states and heighten taxpayer resistance there. Some Republicans seeking to avoid higher marginal federal income tax rates may be inclined to compromise for a cap on state income tax deductions or an overall cap on itemized deductions. Those who favor a "flat tax" regime would also support curbs on itemized deductions, which are the secret handmaidens of progressive tax structures.

As readers can see, the impact of a cap on deductions depends on several key factors including the state and local tax structure and how much house each taxpayer has bought and mortgaged. Even an across-the-board cap on deductions will have an impact eventually on housing prices, if affluent homeowners figure that they've essentially lost their mortgage deductions. So property prices and property taxes are clearly in play here.

As an alternative to raising marginal income tax rates on the rich, a "stealth tax" alternative would be a ceiling on total itemized deductions of $100,000 or 3 percent of income if greater. An absolute limit would be unduly punitive to residents of high-tax states, who would arguably be better off with the higher marginal tax rates they can avoid anyway from income on capital gains and municipal bond interest.

It's far too early to predict how Congress will approach the issue of itemized deductions, but it's early enough to warn state and local government officials that there is plenty at stake here if Washington decides it's easier to cap deductions than to raise upper-income-bracket tax rates. Given the disparities of interests between states, it's not clear whether they can present a united front in Congress, which will give the lobbying advantage to private interests such as the realtors and mortgage bankers.

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