Leaving Money on the Table: "Federal Offset" Provides Incentive for States to Rely on Progressive Income Taxes

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Seven states—Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming—have chosen to make up for the lack of an income tax by increasing their reliance on general sales taxes.1 The result is an “upside down” state tax system, which imposes higher effective tax rates on middle- and low-income families than on the best-off taxpayers. But this policy choice also has an important, often-overlooked, impact on the federal taxes paid by residents of these seven states. Uniquely among the major state taxes, the income tax can be substantially “exported” to the federal government due to a federal tax break allowing federal itemizers a deduction for their state and local taxes.

This federal tax rule amounts to a matching grant from the federal government to states. But the few states without income taxes get much less “bang for the buck” out of this matching grant than do the more typical states that levy the tax. For states facing difficult budgetary choices in 2010 and beyond, this creates an opportunity for states without income taxes that is not as available to lawmakers in the rest of the nation: these states could actually provide needed tax cuts for the fixed-income families hurt hardest by the current downturn without reducing state tax collections by a dime, by shifting away from their current reliance on sales taxes towards the personal income tax.

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