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End Federal Deductibility of State and Local Taxes by BUSINESSES

January 20th, 2018 Leave a comment Go to comments

New York State is thinking of moving to use payroll taxes  instead of individual income tax in order to tax labor income and also get deductibility for federal taxes. That made me think: why do we allow businesses to deduct state and local taxes on their federal tax returns?

There is a good policy reason NOT to allow that deductibility: it is an indirect way to tax interstate trade.  Cities love for businesses to come and locate, because they impose taxes on them much higher than the value of the government services the businesses use. (In addition,  most new businesses employ people who pay more taxes than they cost in government spending, though sometimes city governments shoot themselves in the foot by trying to attract businesses with workers who are ill-paid and have lots of children who will need schooling and police.) The businesses pass along part of the taxes to their customers in the form of higher prices. The customers, though, often live outside the city and even outside the state. Thus, state and local taxation of business is a good way to shift the tax burden to people from other states.

It’s impractical to try to get at this directly, so courts won’t strike it down unless it’s explicitly a tax on sales to people outside the state or on income derived from out-of-state sales, etc.  But the federal government could at least refrain from encouraging burden-shifting the way it does now when it lets a business deduct its state income tax. If we end this deductibility, businesses will be less apt to locate in high-tax states.

To be sure, once tax considerations enter into business location decisions, they will choose less based on fundamentals, so there will be distortion. A business that ought to locate in California will choose  Alabama instead, just to escape taxes, even though its other costs might be lower in California. But another advantage is that the federal government would raise more income, allowing a reduction in some other tax  and reducing the distortion from that other tax.

Thus, there’s a stronger case for getting rid of federal SALT deductibility for businesses than for individuals.  While we’re on the topic of policy, too, I wish we had gotten rid of the individual SALT deduction completely instead of just capping at $10,000. When a cap,    or partial deductibility is used, almost all of the administrative costs remain— and are increased, slightly. The taxpayer still has to keep his records, and the IRS still has to check his records. So if we’re going to limit something, use a FLOOR, not a  ceiling, or, better yet, get rid of it entirely.

Bottom line: let’s get rid of federal deductibility of state and local taxes for businesses.

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