The federal deduction needs reform

Posted on February 22, 2016

By Jan Moller

There are two key questions confronting Louisiana officials as they grapple with the most serious budget crisis in a generation: How much new tax revenue does Louisiana need in order to maintain the critical services that citizens expect? And secondly – who should pay those extra taxes?

As things stand, Louisianans as a whole are lightly taxed compared to the rest of the country; our state has the fifth-lowest state and local tax burden, according to the Tax Foundation. But the distribution of those taxes is skewed against those who can least afford to pay. While the poorest 40 percent of taxpayers give 10 percent of their income to state and local taxes (mostly sales taxes), those in the top 1 percent give up just 4.2 percent of their taxable income.

Fortunately, Louisiana policymakers have a rare opportunity to reform an unproductive tax break that costs the state nearly $1 billion per year: the deduction for federal income taxes.Fed deduction - who pays?

This tax break has been part of the state constitution since 1974, and allows all individual and corporate taxpayers to deduct their federal taxes from their state taxable income. Unlike many tax breaks that are designed to keep Louisiana competitive with neighboring states, the federal deduction doesn’t do much, if anything, to help Louisiana keep up with its neighbors. Only two other states – Iowa and Alabama – allow this deduction, while four other states allow deductions up to a cap.

As tax breaks go, it’s hard to find one that costs more than the federal deduction – nor one whose benefits flow more heavily to the wealthiest taxpayers. An analysis done by the Institute on Taxation and Economic Policy for LBP found that the deduction cost Louisiana $968 million in uncollected tax revenue in 2015. More than one-third of that (36 percent) helps the top 1 percent of tax filers, who have an average taxable income of almost $1.4 million. Only about 1 percent of the benefits flow to the bottom 40 percent of tax filers – those earning less than $37,000 per year in taxable income.

Compare that to the proposal to raise the state sales tax by 1 percent through a “clean penny,” which appears to be the only tax proposal that’s gaining momentum at the Capitol. Raising the state sales tax would bring in $907 million a year – and is one of the few options for raising the short-term cash needed to fix the $950 million gap in the current-year state budget.

But raising the sales tax would fall much harder on low- and middle-income families than changing the federal deduction, according to ITEP’s analysis. While 57 percent of the cost of repealing the federal deduction would fall on the top 5 percent of income earners, only 13 percent of the extra sales tax revenue would come from the top earners.

"Clean Penny" who pays?

Even if legislators don’t want to eliminate the full federal deduction, they have several options available that would raise less money but still make Louisiana’s tax code much more progressive. One idea is to cap the federal deduction instead of getting rid of it altogether. Three states already use this approach – Missouri, Montana and Oregon – and research suggests Louisiana could raise a lot of money by going this route.

Capping the deduction at $5,000 ($10,000 for married couples filing jointly) would raise an estimated $661 million per year, with 94 percent of that amount coming from the richest 20 percent of filers. More than half (51 percent) would come from the richest 1 percent of households. Fed cap 5k - who pays?

Another proposal – which is based on ideas that have been endorsed by groups such as the Tax Foundation and LSU economist James Richardson – is to use some of the revenue gained by eliminating the federal deduction to lower income-tax rates across the board. This is the idea behind House Bills 31 and 32, proposed by House Speaker Pro Tem Walt Leger III of New Orleans. Under this plan, the federal deduction would be eliminated and income-tax rates would fall by one-half percentage point in each bracket (from 2, 4 and 6 percent to 1.5, 3.5 and 5.5 percent).

HB 31 and 32

It would raise an estimated $389 million per year – with 93 percent of that amount coming from the wealthiest 20 percent of taxpayers. While every Louisiana income tax payer would see lower rates, those at the top would still face a net tax increase because of the elimination of the federal deduction. The bottom 60 percent of taxpayers, meanwhile, would actually see their taxes go down.

Policymakers have an unenviable task ahead of them. They are being asked to find short-term fixes to plug the current-year budget shortfall, while making the kind of long-term structural changes necessary to avoid the kind of budget shortfalls that have plagued Louisiana’s finances in recent years.

If legislators leave Baton Rouge having only raised a penny of sales tax and made some cuts to the budget, their job will only be half complete. Real tax reform means not just raising new revenues, but ensuring that tax increases fall most heavily on those who can most easily afford to pay. Reforming the outdated federal income tax deduction is the place to start.

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