Fiscal Federalism and Tax Progressivity: Should the Federal Income Tax Encourage State and Local Redistribution?
49 Pages Posted: 14 May 2004
One of the central tenets of fiscal federalism is that redistributive policies should be undertaken by the most central level of government rather than state or local governments. This Article highlights and critically examines the ways in which the current federal deduction for state and local taxes (SALT) frustrates this goal. As presently designed, the federal SALT deduction encourages state and local redistribution in a variety of ways. For example, current law (i) limits SALT deductions to itemizing taxpayers, (ii) favors progressive income and property taxes over regressive sales taxes, and (iii) confers the largest subsidy on taxpayers with the highest incomes. In combination, these features of the SALT deduction give state and local governments an incentive to skew tax burdens in favor of greater progressivity - an outcome that is exactly contrary to the central normative prescription of fiscal federalism regarding the assignment of redistributive policies to the national government. Working from this insight, the Article makes the normative case against the deduction for state and local taxes as currently designed. The principal argument is that the state and local tax deduction should be distributionally neutral - i.e., the amount of the SALT subsidy flowing to residents of any state or local government should not vary based upon the distributional properties of that government's tax burden. Various reform options that would satisfy the principle of distributional neutrality are examined, including outright repeal and flat-rate refundable tax credits. While such reforms would make the federal income tax burden more progressive, they would also likely encourage state and local governments to adopt less progressive tax systems. The article concludes that this outcome - a more progressive federal tax structure and a less progressive state and local tax structure - is more consistent with basic principles of fiscal federalism than current law.
Keywords: Taxation, Public Finance, Fiscal Federalism, Redistribution
JEL Classification: H71
Suggested Citation: Suggested Citation