The Institute on Taxation and Economic Policy (ITEP) this week published a new policy brief whose conclusions may be surprising to those who don’t spend their days analyzing the intersection of state and federal tax policy.
The brief, How State Tax Changes Affect Your Federal Taxes, outlines how the “federal offset,” or the deductibility of state taxes from federal taxes, affects taxpayers’ bottom line. The brief recommends that, when debating tax changes, state lawmakers consider how federal tax deductions for income, sales and property taxes affect taxpayers.
“If lawmakers want to cut their state income tax, they should consider the fact that a significant percentage of that tax cut will not end up in their constituents’ pockets because they will have a lesser amount of state taxes to deduct from their federal taxes and, thus, will have higher federal tax bills,” said Carl Davis, research director at ITEP. “And even if it is sometimes politically unpopular, increasing income taxes has the opposite effect. Policymakers should keep in mind that if they raise state taxes, the federal government will shoulder some of that increase because state residents will receive larger deductions from their federal income taxes.”
The bottom line is if a state cuts its income tax, it is sending more of its residents’ money to the federal government, and if a state raises its income tax, it will bring more federal dollars to the state. The same is true to a lesser extent with regressive sales and property taxes. But the fact that state taxes are only deductible for those who earn enough to itemize their deductions means that regressive state tax changes—including tax cuts that benefit top earners—are a lousy deal for states relative to progressive reforms.
With this in mind, Davis cautions that the federal offset is only applicable for taxpayers who earn enough money to itemize deductions. Further, he stated, because of the generally regressive nature of all state tax systems, most states are not receiving as much benefit from the federal offset as they potentially could.
“When lawmakers enact targeted low-income tax cuts, they’re targeting all or nearly all of their tax reductions to state residents,” he wrote. “Instead, states too often levy the highest effective tax rates on their poorest residents.”