Topsy-Turvy: State Income Tax Deductions for Federal Income Taxes Turn Tax Fairness on its Head

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The budget outlook for state governments is bleak. Despite evidence that revenues are rebounding, there is a general acknowledgement that ?broad fiscal conditions remain fragile. The need for public investments—particularly health care for low-wage or unemployed workers and their families—is greater than ever. An increasing number of states are struggling to keep their fiscal year 2012 budgets in balance, and shortfalls – totaling $111.9 billion or 17.6 percent of these budgets – have opened up in 44 states.2

In this context, states must find ways to generate additional revenue without increasing the tax load on individuals and families struggling to make ends meet. For six states—Alabama, Iowa, Louisiana, Missouri, Montana, and Oregon—one straightforward approach would be to repeal the deduction for federal income taxes paid. In tax year 2011 alone, these six states are expected to lose a total of $2.5 billion due to this single tax break, with losses ranging from $46 million to $643 million per state. Repealing the deduction would help these states reduce their large and growing budgetary gaps and make their tax systems less unfair.

This report explains how the deduction for federal income taxes works and assesses its impact on state tax fairness and state budgets.

Read the Full Report (PDF)