The Subsidy from State and Local Tax Deductibility: Trends, Methodological Issues, and Its Value After Federal Tax Reform

Working Paper 97-8
by Robert Tannenwald
1997 Series

Even though the momentum of the "devolution" movement has slowed, federal intergovernmental grants will probably be cut substantially during the next five to ten years. Federal tax reform could further erode federal assistance by eliminating the deduction for state and local personal income and property taxes. This deduction subsidizes the net cost to taxpayers of financing an additional dollar of state and local spending. In the language of economics, deductibility reduces the marginal "tax price" of state and local public goods. This paper clarifies methodological issues in the estimation of this tax price, updates estimates of tax price by state, and evaluates the impact of state and local taxes on the level and dispersion of state-specific tax prices. The paper argues that previous estimates of tax reflect assumptions, often implicit, concerning the distribution of influence among consumers over the level of public goods provided by a given jurisdiction. These assumptions, often implicit, do not always square with the estimators' preferred theory concerning how the level of public goods is determined. Even when they do, they fail to take into account the deductibility of state and local business taxes from federal taxable profits. The estimates provided in this paper attempt to address these two problems. An earlier version of this paper was presented at the Allied Social Science Annual Meetings, New Orleans, January 6, 1997.

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