No, Mr. President, the Deduction for State Income Tax Is Not a Loophole

The Trump-GOP tax plan, based heavily on tax cuts for corporations and the wealthy, would cost $2.4 trillion in lost federal revenue over 10 years, according to the nonpartisan Tax Policy Center. And the only “loophole” the plan closes to offset this enormous revenue loss is the deduction for state income tax paid by individuals.

Is that a loophole? Hardly. A loophole is a tax code provision that allows taxpayers and their advisers to game the system, typically through the generation of artificial deductions or credits that reduce tax. The deduction for state income tax doesn’t fit that description.

Your state income tax bill is a cost of producing income, just like the expenses a business pays to produce its income. And, unlike most business expenses, you have no control over your state income tax liability.

Above all else, the deduction for state income tax is fair. Compare, for example, a married Oregon couple who earn $136,000 and pay $11,000 in state income tax, leaving $125,000 after the involuntary state tax payment, with a Texas couple who earn $125,000 and pay no state income tax. Those two couples are in the same position, but unless the Oregon couple can deduct state income tax on their federal return, they likely will have a higher federal tax bill.

Trump and others try to justify the elimination of the deduction for state income tax on the basis that it is payment for the services state governments provide. But there are two flaws in that logic. First, there’s no proportionality between a person’s state tax bill and the services he receives. A family that receives twice as much as the average resident in services because they have a large number of children in public education or have a house fire put out by firefighters does not pay twice as much in state tax.

Second, states with alternative revenue sources provide the same services, but nobody seeks to tax residents of those states on the receipt of those services. For example, the services that residents of Texas receive effectively are non-cash distributions of the state’s oil and gas royalties, but no politician would dare suggest we tax Texans on the value of those distributions.

Even putting aside the blatant unfairness, eliminating the deduction for state income tax is poor federal tax policy because it indirectly puts pressure on state revenues. When no federal level deduction is allowed for state income tax payments, the real, after-tax cost of those payments increases. That means the cost of living in states that depend on income tax revenue increases relative to states with alternative revenue sources, which in turn places undue pressure on legislators in those states to reduce tax rates and to pay for those rate cuts by paring back spending on infrastructure development and education.

The worst effects of eliminating the state income tax deduction will be seen in states with major metropolitan areas that straddle borders between two or more states with different income tax rates. Consider, for example, the Portland metropolitan area, which includes residents of both Oregon and Washington. Oregon charges income tax, whereas Washington does not. If the deduction for state income tax is eliminated, Oregon legislators could face a “take it or leave it” Hobson’s choice: reduce tax rates on affluent Portland taxpayers and slash the state budget, or watch as wealthier residents move to Washington, which would result in a decline in Portland property values relative to those just on the other side of the state border.

In the end, a large portion of the federal revenue raised by the elimination of what Trump calls a loophole allowing for the deduction of state income tax may be matched by a reduction in state level revenue — including revenue that currently funds the Oregon budget.

Republicans have talked for years about the need to close tax loopholes. Rather than eliminating the state income tax deduction, they should go after the ones that have allowed the wealthy and big corporations to rig the rules in their favor.

Bob Lord is a veteran tax lawyer who practices and blogs in Phoenix, Arizona. He’s an associate fellow of the Institute for Policy Studies.