Watch Out California, the Presidential Contenders Are Coming at You
Watch out California; the 2016 Presidential contenders are coming after the state's most prized federal subsidy: the state and local tax deduction. In an odd bootleggers-and-Baptists alliance, the state and local tax deduction is California's Top 1% and progressive movement's best friend. For the Top 1%, it allows them to continue living the California Dream despite the state's income tax progressivity and for the state's progressive elite, the deduction masks the true impact of the Golden State's high and volatile tax system. But with this deduction potentially on the chopping block, California may finally be forced to seriously reform the state's severely dysfunctional tax code.
Since the U.S. implemented the federal income tax code in 1913, the state and local tax deduction has existed. Those who itemize their deductions can offset their federal tax bill by the value of their state and local tax bill. The thinking was the federal code shouldn't burden individuals with double-taxation. But in practice, the deduction simply is a federal subsidy, transferring wealth from low tax, low income states to the wealthiest living in high tax states. Here's why: the wealthy are substantially more likely to itemize their deductions and those living in high tax states have even more incentive to do so. For instance, 58% of 2014 itemized state and local tax deductions occurred among tax filers making $100,000 or more.
Presidential Contenders Take Aim at the Deduction: In order to reduce taxes, but not blow a hole in the federal budget, Presidential contenders must offset the lost revenue that could accompany a rate reduction. The obvious choice is to limit or eliminate the more specialized deductions. According to the Tax Foundation, the biggest loser of the Presidential tax reform plans are the itemized deductions, with the state and local tax deduction clearly in the cross-hairs. As of September, five candidates have incorporated limiting itemized deductions as part of their plans, but one candidate - former Florida Governor Jeb Bush - has proposed eliminating the state and local tax deduction altogether. While his tax plan fundamentally aims to lower rates and broaden the base, as a former governor of a no-income-tax state (hence Florida was a major funder of this federal subsidy), Bush's plan would also put an end to this Top 1% - progressive alliance.
California is the Epi-center of the State and Local Tax Deduction Subsidy: California has a domestic migration problem - in 2014, its out-migration ratio was 1.2 persons - but those leaving aren't who you'd naturally think. Rather than the state's highest earners, they are middle-class young professionals, who can't afford the intensifying Golden State squeeze. Why aren't the wealthy heading for greener (i.e. less tax-heavy) pastures? Because, they deduct their large state and local tax bills from their federal taxes lessening the impact of California's leaders actively increasing their taxes. In 2013, 30% of state and local tax deductions went to households in the Top 1%, with a total of 80% accumulating in the highest quintile of households. And based on 2013 IRS statistics, California federal tax filers accounted for over one-fifth of the total state and local tax deductions and those making $1 million or more accounted for almost one-third of the nation's $1 million-plus state and local tax deductions. Needless to say, California's progressive leaders and the state's wealthiest both benefit immensely from the deduction.
Eliminating the Deduction Would Prompt Tax Reform: The flaws of California's tax code create a cascade effect: 1) a very progressive structure creates a reliance on California's wealthiest of taxpayers, who are 2) extraordinarily reliant on capital gains income, which 3) creates massive volatility in revenues, so that 4) California experiences massive booms and busts in the general fund, which in turn 5) forces state legislators to haphazardly expand and slash crucial government services. The state and local tax deduction, arguably, may be the single-most important factor preventing the reform of this well-documented deficient system. Because the wealthy are, in essence, shielded from the progressive elites' tax-and-spend agenda, they don't change their behavior to either reduce their state tax bill or seek refuge in low-tax states. Hence, this tax-the-rich scenario is artificially buoyed by the federal government's subsidy. Removing it would alter the higher-earners' incentives, which would remove whatever stability does exist in California's progressive tax system, forcing the state's leaders to reform its taxation "house of cards."
I doubt Jeb Bush - or the other Presidential candidates, for that matter - were thinking of state tax reform when they developed their federal tax plans, but that is exactly what the ripple effect of eliminating the state and local tax deduction would be. And Sacramento will be out of excuses to delay reform any further.
