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Saturday, December 22, 2012

Federalism and Tax Reform

The previous post described the tricky politics of limiting the tax deduction for charitable contributions. Tax reform also has implications for federalism, as it would affect the financing of state and local governments.
At the Los Angeles Times, Michael Hiltzik argues that limiting other deductions would also have bad side effects.
You may be unaware of the local ramifications of one of the proposals currently at play in the danse macabre that passes for fiscal negotiations in Washington.

This is the plan to cap federal tax deductions at either a set figure or a percentage of income. Either way, it would strike deepest and hardest mostly at residents of California, as well as other populous states with high levels of government services, high state and local taxes, and relatively expensive housing.
The mortgage interest and state and local tax deductions are among the most important tax breaks that would be capped under this sort of proposal. They're linchpins of middle-class tax planning in the most heavily affected states, which also include New York, Illinois, Massachusetts and Connecticut.
One common argument raised against the deduction for state and local taxes is that it forces the rest of the country to subsidize the high-tax predilections of a few high-spending states.
Yet the list of states with the lowest per-capita state tax burden on their own citizens is eerily similar to the list of those that receive the most federal money relative to their residents' federal tax contribution. So who's subsidizing whom?
The New York Times reports:
Timothy L. Firestine, the top government administrator in Montgomery County, Md., is crunching numbers in his battle to preserve the hallowed tax exemption on municipal bonds.

The average annual property tax bill in his affluent suburban Washington county would ultimately rise by at least $100, he estimates, as a consequence of a proposal by the Obama administration to modestly tax the interest that wealthy investors receive from municipal bonds. That’s because, he says, if investors see less of a tax break, they will demand higher interest to make up the loss, and higher interest rates will mean higher borrowing costs for governments.
Mr. Firestine is on the front lines of a lobbying campaign by local and state governments, bond dealers, insurers and underwriters that is trying to pre-empt any attempt to limit or even kill the tax exemption. The administration has proposed capping the tax break that America’s highest earners now receive from municipal bonds, as part of its campaign to close loopholes and enlist more of the rich in fighting the federal deficit. Analysts expect such a cap to be part of a comprehensive tax overhaul package that Congress will take up next year, under a broad fiscal framework now being negotiated by President Obama and House Speaker John A. Boehner.