What tax reform would mean at the state level

What would fundamental changes in the federal tax code mean for state and local governments? Would it limit their ability to raise or borrow money? Would it make their revenue systems more or less progressive or even work more smoothly?

Last Friday, I participated in a joint Tax Policy Center and UCLA Law School conference sponsored by the MacArthur Foundation  on what federal reform would mean to governments beyond the Beltway.  And the short answer is: A lot.

Some change might be good, while other reforms might be quite disruptive. The bottom line seems to be that Congress could go a long way towards fixing the federal system without destroying state revenue codes—but only if reform is done carefully.

Take, for example, the federal deduction for state and local taxes, which reduces federal revenues by more than $70 billion annually. Policymakers have been talking about repealing it at least since the Reagan Administration.

Since most low- and moderate-income taxpayers don’t itemize, the deduction does them no good at all. Even many middle- and upper-middle class households who do itemize lose the benefit of the deduction if they fall into the dreaded Alternative Minimum Tax.

Still, the system encourages states to rely on deductible levies such as income and sales taxes. The good news is that state income taxes can be progressive (though many are not). The bad news is income and sales tax revenues are sensitive to changes in the economy and their decline is one reason states are in deep fiscal trouble today.    

What would happen if Congress got rid of the deduction?  To start, while upper-income households would owe more, it wouldn’t matter to the 70 percent of households that don’t benefit now. According to UCLA law vice-dean Kirk Stark and my TPC colleague Kim Rueben, while taxpayers in all states benefit from the deduction, the effects of repeal would be concentrated in a few, high-income, high tax states such as New York and California. Other alternatives, such as turning the deduction into a credit, could benefit lower-income households by reducing their federal tax.

Another item on many tax reform lists is the mortgage interest deduction. Completely eliminating the deduction would drive down home values, at least in the short-run, and hammer state and local property tax revenues. But more modest reforms, such as turning the deduction into a credit, would have relatively modest effects on state and local revenues overall, according to Andrew Hanson of Georgia State University and David Albouy of the University of Michigan.

What about a very broad federal reform, such as creating a national consumption tax? That could turn state tax systems upside down, but the two structures may still be able to live well together. Canada has a national Value-Added Tax, while its provinces operate their own sales levies or piggyback off of the federal tax.  

Could the U.S. pull this off? Michael Smart of the University of Toronto felt such a transformation is doable, though not easy. But Stanford University’s Charles McClure, a veteran of Washington’s tax reform battles, was far less confident.  

Canada, Charlie noted, was a “best case.” The Canadians replaced a bad tax with a good one and did not have to worry about raising new revenues, yet political opposition to reform was still strong. By contrast, it would be much tougher in the U.S., which suffers from a more toxic political environment, probably would be adding a consumption tax to an income tax, and would likely have to use reform to raise revenue.

While there was lots of healthy debate in LA last week, the participants did agree on one thing: When Congress does get around to federal tax reform, it better not forget what these changes will mean to the states.