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End the State and Local Tax Deduction for Businesses

February 15th, 2018 Leave a comment Go to comments

Why do we allow businesses to deduct state and local taxes from their income when they pay federal income tax? I propose that we eliminate that deduction. Nobody has suggested this, but it is really an obvious extension of the idea of eliminating them from the personal income tax.

Currently, employees can deduct up to $10,000 in state and local taxes paid from your taxable income for federal income tax. (The limit is $10,000 instead of $0 only as a political compromise; it should be $0). If you get business income from a pass-through entity such as a sole proprietorship, partnership, or small corporation, though, you do get to deduct the state and local taxes attributable to that business. A corporation paying corporate income tax can also deduct state and local taxes. Note, however, that pass-through income (profit) is listed on your personal income tax return, and you can’t deduct the state income tax you pay on that beyond the $10,000 limit.

One’s immediate reaction to the idea of eliminating deductability for businesses will be, “State and local taxes are a cost of doing business, and our objective is to tax business profits, which are revenues minus costs.” But taxes are different from other costs. We have to look carefully at why we think that a business which is located in a state with high taxes should pay less in federal income tax than another, identical, business which is located in a state with low taxes.

I’m going to post this draft now, because I want to get the idea into circulation. I hope to come back and refine these points.

1. We don’t apply this argument to personal income taxes. There, we say that the person is getting something for his taxes— it’s a form of compulsory consumption. Also, few states allow a deduction for federal taxes paid, for personal income taxes at least.

2. On the other hand, with businesses it is not all compulsory consumption. Part of it is indeed to pay for the expenses the business creates for government— roads, police, etc.

3. But in fact businesses get overtaxed. They pay more taxes than they cost the state or locality in government services. That is why states and cities try so hard to attract businesses to locate there. They have to promise tax abatements at first, because the businesses know that they’ll be held up by the tax bandits once they’ve committed their investment and can’t move easily. The federal government should not encourage that kind of extortionary taxation by letting it be a deductible expense any more than they should let bribes to aldermen be deductible. (Are bribes deductible? I don’t know. Illegal income is taxable, but are illegal expenses deductible?)

4. More important, there is the incentive to impose a tax on a business which will pass it on to customers located in other states. We want to discourage that. Really, there’s even case to be made for having a nationwide standard state-and-local business tax, at least for businesses with interstate trade. But I like federalism, so I will not argue for that solution. But we should not have the federal government encourage states to, in effect, tax the citizens of other states.

5. An alternative would be to allow a standard deduction of 4% for state income tax and 2% for local property tax. This would eliminate recordkeeping and other complexities. That would be better than our current $10,000 limitation for personal income taxes, which should do the same thing.

6. An important advantage of eliminating any deduction is simplification. If businesses can’t deduct taxes, they won’t have to keep track of them for tax purposes, and the government won’t have to audit them. Record-keeping itself is probably not onerous— I expect the business would do it for cost accounting anyway— but other complications arise too. For example, if a business overpays its state taxes in 2018, then the state will issue a refund, which will have to show up as income in 2019. There must be lots of issues in tax law that come up, too. Thus, it isn’t enough to say a deduction’s costs and benefits aren’t clear— there is always one big clear cost, which is the cost of compliance and auditing.

7. A huge advantage of eliminating the deduction would be the revenue raised.  Businesses paid about $654 billion in state and local taxes in FY2014, about 42% of all state and local taxes (a pretty constant percentage since at least 2003) (I subtracted out the $34 billion of this which was indivdiual income tax on business income– see Table 1.)

Thus, eliminating deductibility would, at a 20% tax rate, would generate about $130 billion of extra federal revenue annually.

Do you remember how the 2018 tax bill was limited to increasing the deficit by $1.5 trillion over the next 10 years? Getting rid of business tax deductibility would just about eliminate that increase in the deficit. It would cause states to reduce their tax rates, I think, which would reduct the effect a little, but it would easily save $1 trillion of the $1.5 trillion. And that doesn’t even take into account that with less onerous state taxation, business profits would rise, which would go the opposite direction and pay taxes that would reduce the deficit even more.

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