Cost of Tax Breaks for States, Localities May Be Exposed

If approved, a new rule would make it easier for groups to challenge the tax exemptions that state and local governments get from the feds.
by | June 7, 2016
Paul Ryan and Obama have both proposed repealing or limiting the tax-exempt status of municipal bonds. (AP/Pablo Martinez Monsivais)

A proposed change in financial rules would shed more light on what the federal government gives up in tax breaks to state and local governments. If approved, it could provide ammunition to groups that want to reduce those benefits as a way of eliminating the federal budget deficit.

The new rule, proposed by the Federal Accounting Standards Advisory Board (FASAB), would require the feds to include in annual financial reports the "revenue impact" (but not a precise calculation) of all Washington's lost revenue from tax breaks. The U.S. Treasury Department already estimates the cost of these expenditures, but they aren't included in federal annual financial reports.

According to the Treasury Department, the provision that lets filers deduct their state and local income and property taxes from the income they declare to the federal government cost $84 billion in lost revenue just this year. An additional $32 billion accounts for state and local governments' much-beloved tax exemption for municipal bonds, which critics have been trying to repeal for years.

But the largest federal deduction by far is the one employers get for their contributions to employee health insurance premiums and medical care. That cost the feds $211 billion in lost revenue this year. For perspective, the federal budget is a little under $4 trillion, while the budget deficit is a little over $500 billion.

Justin Marlowe, a Governing contributor and public finance professor at the University of Washington, says the change "would draw more attention to the particularly big areas of deductions and exemptions," and help critics of those expenditures make a case for getting rid of them.

Both Congress and President Obama have proposed limiting or repealing the tax exemption for muni bonds, but state and local government groups have lobbied hard to keep it. That's because the benefit allows states and municipalities to offer a lower interest rate on those bonds, meaning it costs less for them to finance infrastructure projects. A study last year found that the tax-exempt status of muni bonds has saved governments an estimated $714 billion in extra interest payments from 2000 to 2014.

The idea of limiting or taking away the ability of people to deduct their state and local income and property taxes from the income they declare to the federal government has been less prevalent but has nevertheless been part of discussions about overhauling the federal tax code. Last month, U.S. House Speaker Paul Ryan said he favored nixing that deduction over the muni bond tax exemption. State and local government groups have said they would fight such a proposal.

The new accounting proposal, however, isn’t meant to attack any of the federal government's tax breaks. It simply aims to give those tax policies context, said FASAB Chairman D. Scott Showalter.

“Because tax expenditures are not explicitly reported as appropriations or displayed in [other financial statements], we need to shine a light on them,” he said. “Doing so would allow users to gain a more complete understanding of the service efforts, costs and factors impacting federal revenues.”

The proposal is open for comments until Sept. 15. Marlowe anticipates that it will be criticized for "politicizing the financial report” just as the Governmental Accounting Standards Board was criticized for a new rule requiring governments to report tax expenditures related to economic development incentives.