A Republic of the Mind: Cognitive Biases, Fiscal Federalism, and Section 164 of the Tax Code

Abstract:     
Our federal government annually donates more than $75 billion in potential revenue to the States under section 164 of the Tax Code, the provision allowing itemizing taxpayers to deduct the cost of the state and local income, property, and sales taxes they paid during the tax year. The deduction is, in theory, supposed to further federalism, by shifting revenues - and therefore regulation - downwards from the federal government to states and their local subsidiaries. What few writers seem yet to have recognized, though, is that using the deduction for that end, rather than some other fiscal tool, may have the perverse effect of undermining the efficiency, transparency, and even the democratic character of those local governments.

More generally, however, my goal here is to show that section 164 is about more than (boatloads of) money. Other commentators, especially economists, have recognized that the deduction may shift the locus of regulation from federal to state and local governments. In this Article I argue that the deduction may play a large but currently underappreciated role not only in the relative sizes of local and federal governments but also in the structure and effectiveness of sub-national governments. Local governments develop in response both to direct political demands and also the indirect pressure generated by the threat of "exit," or out-migration to a more efficient or more responsive jurisdiction. The deduction, I argue, significantly affects both of these factors - most obviously by reducing exit pressures, but also by in more subtle ways transforming the processes of direct politics.

Number of Pages in PDF File: 38

Keywords: SALT, deductibility of state and local taxes, horizontal equity, fiscal federalism, spillovers, cognitive bias, exit, Tiebout

Accepted Paper Series