“Why should lower-tax inland states subsidize high-tax coastal states like California and New York?”
Of course, the quote above taken at face value is not true (even before the 2017 Tax Act, CA and NY contribute far more into the Federal coffers than it receives), but it sounds like a fair question to ask in discussing the merits of the State and Local Tax (SALT) deduction, which was one of the biggest victims in the 2017 Tax Act. Even Blue State Liberals can have trouble justifying why this deduction makes sense in principle.
Therefore, I want to point out some of the less obvious merits to the deduction, not to argue that we should keep the deduction, but to balance the discussion. It has many drawbacks as well but they’re more well known so I will not discuss them here. Moreover, I’ll focus on the income tax deduction (since there’s less merit to the property tax deduction). If you’re curious about my opinion, read to the end.
You can see my previous post about the politics and optics of this change, specifically its redistributive nature. This post will focus on its policy and economic merits.
The deduction was in place when the income tax was instituted at the Federal level to protect the state’s ability to levy taxes entirely consumed by the Federal taxes. You can see a clear illustration of this principle when the top marginal rate was high (94% during WWII). Without this protection, states would have had virtually no power to levy taxes on high-income earners.
Of course, given where our top marginal rates are now (37% post-tax-act), this fear seems a bit strange. Perhaps if we believe that rates will never go up as high, this justification should be left to the economic historians. But if a national mobilization were to become necessary (i.e. major war) and the Federal government needed to finance it, we may again see merit in this argument.
Positive Externalities of Public Spending
Some forms of public spending generate positive externalities–that is, it produces benefits to those who are outside of that jurisdiction. For example:
- tighter emission standards in California benefit the world overall and its neighbors especially.
- investment in education (including higher education) produces a more educated populace, many of whom will end up working (and paying taxed) in other states.
- investment in public facilities are often used by residents of other states (or even countries)–not all of these are national parks that are funded by the Federal Government.
- generous benefits will tend to draw a more dependent crowd, reducing costs in other states. Imagine the migration that would ensue if only California offered universal health care to everyone.
Negative Externalities of Tax Cuts
With fluid borders, local governments are locked in a Tragedy of the Commons situation where one state lowering their taxes creates pressure on the coffers of other states, as the wealthy and mobile threaten to (and in many cases decide to) move out.
This pattern may be more visible when companies do it, like when Kansas and Missouri took turns in paying a company to move its headquarters back and forth between the two states or when New Jersey and others offered $7 billion to Amazon, worth almost $600 billion, to locate its second headquarters there.
States are not immune to wealthy individuals packing up for another state, either. Each one may be less prominent compared to a well-known global behemoth like Amazon, but there are many more individuals than businesses. See how “one man can move out of New Jersey and put the entire state budget at risk” for one story.
Despite the merits described in this post, I think it’s outweighed by its many downsides: The redistributive effect (It only benefits high earners), its imprecision in affecting externalities, and the cost. However, this isn’t a slam-dunk case where the downsides are clearly more significant.
The deduction should be eliminated along with many other deductions (including charitable giving deduction, mortgage interest deduction, etc), for both individuals and corporations. Insofar as public spending by a government entity generates benefits outside of its jurisdiction, that positive externality should be properly quantified and directly subsidized (i.e. a Federal transfer to the state for achieving certain educational results). The deduction is too blunt of an instrument to properly price in the various externalities of state spending.