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Indirect Federal Subsidy Through State and Local Tax Deductions

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Yonghong Wu
September 9, 2022

The deductibility of certain state and local taxes isn’t just a benefit to taxpayers. States and localities themselves benefit, as this deductibility makes it possible for the federal government to pick up a portion of the cost of state and local taxes. In essence, these tax deductions have become an indirect type of federal subsidy in contrast to direct federal aid to state and local governments.

All state and local governments collected $1,295 billion and $1,377 billion in property tax, general sales tax and individual income tax revenues in 2017 and 2018, respectively. The total indirect federal subsidies are about 14.5 percent and 6.8 percent of the deductible taxes in the two years. In other words, the federal government paid 14.5 percent and 6.8 percent of state and local property tax, general sales tax and individual income tax through the deduction of those taxes from the federal income tax base.

Unfortunately for state and local budgets, federal tax reform has altered the deductibility of state and local taxes. The most recent one is the Tax Cuts and Jobs Act of 2017 (TCJA) that caps the deduction of these taxes to $10,000 per filer per year. While the cap reduces federal tax expenditures, it adversely affects state and local finances as it substantially cuts back this indirect federal subsidy. Another provision of the law raises standard deductions and hence reduces the number of filers who choose to itemize deductions.

Using the data from federal income tax returns, I have calculated the size of the indirect federal subsidy through tax deductions by state and then compared this federal subsidy pre-and post the change in the law. This revealed that the indirect federal assistance to the states declined by about 50 percent during 2017–2018.

My work made it abundantly clear that the impact of this indirect subsidy on the states varies dramatically. Following are two of my more significant findings.

  • States with higher per capita income and per capita taxes tend to have been less affected by the law.

For instance, California and Maryland are ranked #6 and #5 by per capita income, and #6 and #7 by per capita taxes in 2017. However, the percent drop of per capita indirect federal subsidy is the smallest for California (-39.7 percent) and 4th smallest for Maryland (-43.4 percent).

The states that were hit hardest have modest levels of affluence and tax burden. The four deepest cuts occurred in Nebraska (-74.4 percent), Iowa (-67.2 percent), Wisconsin (-65.7 percent) and Maine (-65.7 percent), which are ranked from #20 to #31 by per capita income and from #12 to #17 by per capita taxes in 2017. A plausible interpretation is that many filers in the states fell between the standard deduction thresholds of 2017 and 2018 and switched to standard deductions to acquire larger tax relief.

  • The law narrows the disparity in the extent to which major state and local taxes are subsidized.

The indirect federal subsidy in 2017 accounted for over 19 percent of the three broad-based taxes in six states, including California, Delaware, New Jersey, Connecticut, Oregon and Maryland. The high subsidy rates are due to either relatively large amounts of indirect subsidies received by such states as California and New Jersey or relatively low levels of the deductible tax revenues in the state of Delaware. On the other hand, the indirect federal subsidy rate is below 7 percent in the following seven states: South Dakota, North Dakota, Mississippi, Alaska, Wyoming, Louisiana and Tennessee. The low subsidy rates are primarily due to relatively small amounts of indirect federal subsidies received by most of these states.

When the SALT deduction was capped in 2018, California, Connecticut, Maryland, New Jersey and Oregon remained the most subsidized states. However, the percentage of SALT subsidized is substantially reduced for each of the five states. On the other hand, Alaska, Nebraska, North Dakota, South Dakota and West Virginia are the least subsidized states. Only 2.5 or a lower percent of the deductible taxes are refunded through SALT deductions in 2018.

In 2017, the percentage of SALT subsidized ranges from 5 percent (South Dakota) to 21.6 percent (California), and the difference between the maximum and minimum values is 16.6 percentage points. In 2018, the range is only 10.2 percentage points, with maximum and minimum percentages being 12 percent (California) and 1.8 percent (South Dakota). The standard deviation declines from 4.5 percent in 2017 to 2.3 percent in 2018. It suggests that the recent tax reform moves in the direction of equalizing the indirect federal subsidization rate across states.

The results demonstrate the massive and uneven distribution of the indirect federal subsidy to states and localities. They also reveal that the Tax Cuts and Jobs Act of 2017 T led to two significant shifts. It reduced the indirect federal subsidy by substantial amounts, which has had an impact on state and local tax policymaking ever since. In addition, it narrowed the disparity in states’ receipt of this federal assistance.

Author: Yonghong Wu, Professor and Director of Graduate Studies, University of Illinois, Chicago, and faculty advisory panel member, Government Finance Research Center.

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