During this election season, the presidential candidates have offered up their federal tax reform plans which, depending on who you asked, would either provide much-needed relief for hard-working families or tax America’s middle class out of existence. But there’s an important aspect of the conversation that has been left out. Neither of the candidates have explained how their plans would really affect state and local governments.
Let me flesh this out. Under that hoary old concept of reciprocal immunity, no level of government should be taxing another government’s essential activities, like, say, financing of public infrastructure -- a critical issue in the decade to come and one the states have increasingly funded. The Congressional Budget Office tells us that public spending on transportation and water infrastructure totaled $416 billion in 2014. State and local governments provided $320 billion of it; the federal government, only $96 billion. According to the Boston Federal Reserve, annual capital spending by state and local governments over the last decade accounted for 12 percent of their total spending. Capital investments account for 14.4 percent of outstanding state and local long-term public debt.
As to the federal government, this year will be the sixth year of austerity in domestic appropriations, and the cumulative effects on transportation infrastructure are dramatic: Transportation Department programs funded through annual appropriations are projected to be at their lowest in 14 years.
So when a new president comes into office in January, how might campaign tax reform promises affect the ability of states and local governments to make critical investments? A key factor will be whether a new administration seeks to interfere with the country’s strong tradition of state tax sovereignty -- a challenge as old as the republic. It was Alexander Hamilton -- not the one on Broadway -- who wrote that “individual States should possess an independent and uncontrollable authority to raise their own revenues for the support of their own wants ... any attempt on the part of the national government to abridge them in the exercise of it would be a violent assumption of power unwarranted by any article or clause of the Constitution.”
Apart from the muni tax exemption -- which helps states and localities to borrow money for infrastructure -- eliminating the deduction for state and local taxes is one campaign promise that could most directly impact those governments. It would mean that Americans pay federal taxes on their state and local taxes. So it is that presidential candidate Hillary Clinton proposed limits on high earners’ deductions, and candidate Donald Trump said he would cap the value of individual deductions. He also promised to “reduce or eliminate some corporate loopholes” and cap the deductibility of business interest expense.
The target of their proposed changes involve deductions that currently serve to ensure the federal government does not, in effect, impose federal taxes on state property and sales and use taxes. If implemented, they would undo and reverse important provisions in our federal tax code. These are provisions that were intended, as Aretha Franklin used to belt out, as R-E-S-P-E-C-T for states and local governments.
Thus, with a new president moving into the Oval Office in January, campaign promises could transform the authority of state and local governments to finance public infrastructure and raise revenues to meet critical public needs. And it would come at a particularly inopportune time: Total state general fund tax collections rose only 2.3 percent in the last fiscal year, less than half of the increase in fiscal 2015 -- or what Rockefeller Institute budget analyst Lucy Dadayan calls a “red flag” for states.