Time to Repeal State Deductions for Federal Income Taxes

May 1, 2017

Dylan Grundman O'Neill
Senior Policy Analyst

Three of the biggest needs facing state policymakers right now are new revenues to fund their priorities in the face of budget shortfalls and federal funding cuts, ways to insulate those revenue streams from unpredictable tax changes at the federal level, and approaches to meet these needs without leaning even more heavily on low- and middle-income families for revenue than they already do. As our newly updated brief shows, the six states that still allow an income tax deduction for federal income taxes paid can advance all three of these important goals. Lawmakers in Alabama, Iowa, Louisiana, Missouri, Montana, and Oregon should strongly consider repealing this costly, regressive, and volatile tax break.

As our brief outlines, these six states collectively will lose about $3.8 billion in revenue in 2017 due to this deduction. In three of the states—Alabama, Iowa, and Louisiana—the deduction is unlimited, allowing every dollar paid in federal income taxes to be deducted from income for state tax purposes. In the other three states, caps or phase-downs limit how much any one taxpayer can take advantage of the tax break. Not surprisingly, the three states without any limits on the deduction lose the most revenue ($2.7 billion combined). Those three states also give more of the break to their highest-income taxpayers than the states that limit it, with around 80 percent of the benefit going to the highest-income 20 percent of residents, though high-income families receive an outsized share of the benefit in every state that allows the deduction.

Some of these states are wisely taking notice and working to address these issues. In Louisiana, Gov. John Bel Edwards, a legislative tax study task force, and the state’s leading tax policy experts have all called for eliminating the deduction. In Iowa, although no major tax changes were ultimately approved this year, the deduction was targeted there as well. And repealing the deduction has also been considered in Alabama as a way of offsetting the revenue loss that would occur if the state repeals its tax on groceries.

With federal tax and budget debates heating up and rampant uncertainty about where those debates may lead, these six states have a clear opportunity to bring in needed revenue, protect that revenue from the whims of Congress, and advance tax fairness at the same time.