How Federal Tax Reform Can Help or Hurt State and Local Governments

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Federal tax reform can affect state and local taxes in several ways. The federal government can create, repeal or change tax expenditures in a way that is passed on to the states because virtually every state has tax rules linked to the federal rules. The federal government can subsidize state and local governments’ ability to raise taxes and can subsidize their ability to borrow funds to finance capital investments. Finally, the federal government can regulate state and local governments’ ability to raise taxes in a way that coordinates and harmonizes their tax rules or in a way restricts their taxing power and makes their tax systems more complex.

My testimony makes four points.

1. Federal tax reform can provide state governments an opportunity to improve their finances by repealing or reducing tax expenditures.

2. The federal income tax deduction for state and local taxes is indeed a tax expenditure that reduces the amount of revenue collected by the federal personal income tax, but in many ways is more justified than many other tax expenditures.

3. The federal government’s practice of not taxing the interest income on state and local bonds is an inefficient way to subsidize state and local governments, and the President’s proposal to extend Build America Bonds would mitigate this problem.

4. When lawmakers consider legislation intended to coordinate tax rules among the states, they must distinguish proposals that will truly achieve this result (like the Marketplace Fairness Act) from those that simply restrict states’ taxing powers at the behest of corporate interests (like the Business Activity Tax Simplification Act).

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