An observation

Note to SK, this is a policy post, but taxes will be discussed.  Read at your own peril. :D

One of the tax law changes enacted last October was one that allows individuals to choose whether to deduct income taxes or sales taxes.  Some of you may remember that prior to 1986 the law allowed people to deduct both sales taxes and state income taxes.   Under that law, sales taxes could be substantiated by receipt purchases or the use of IRS tables to estimate the sales taxes.  The sales tax provision was eliminated in the 1986 tax law restructuring.

Since that point state income taxes were deductible, but sales taxes were deductible.  However, a few states do not have a state income tax. (And some states that do have an income tax tax only business income.)  Instead, they rely on property taxes (which are deductible for everyone) and sales taxes.  As a result, these states generally have higher sales tax rates than those they otherwise might have.

The Senators and Representatives from those states have argued that the removal of the sales tax deduction has placed their states at an economic disadvantage.  Last year they were able to to convince enough of their colleagues to pass a measure that allows people to choose whether they want to deduct sales taxes or state income taxes.  As before, people will be allowed to use actual receipts or estimates from IRS tables.

Opponents of this measure argue that no such disadvantage existed.  I've also heard one such person say, "It's not my fault that your state chose a tax-disadvantaged method of funding."

The problem with the second argument, besides that it doesn't give any reason whatsoever why the law shouldn't be changed, is that most of these states chose their funding structure before the sales tax deduction was revoked.  Changing their tax structure because sales taxes were no longer deductible would have required a major reworking of their entire tax system.  That's always a dangerous thing.  (That's one of the reason that I'm highly skeptical of the idea of replacing the Federal income tax with the so-called "flat tax" or a consumption tax; Congress is almost certain to screw it up.)

As to the first argument, that the older system didn't disadvantage those with no income tax, to be unpersuasive.  To me it seems almost axiomatic that those who live in a state that has two taxes, one of which is non-deductible, pay a larger portion of their tax burden in  non-deductible taxes than those in a state that has three taxes, two of which are deductible.  I would absolutely consider it axiomatic that if they pay a larger portion in non-deductible taxes, that they are at an economic disadvantage.

However, contrary to what the supporters of the new law claim, allowing people to choose to deduct either sales tax or state income tax does not bring the no-income-tax states into parity with the other states;  It gives them an economic advantage.

Why do I say they are now at an advantage?  Simply put, residents of the no-income-tax states are now able to deduct both sales taxes and property taxes, the two primary legs of their tax structure.  Meanwhile, those in other states can still only deduct two of their three primary taxes.  Yes, the ability to choose between sales and income taxes improves their position, but it helps the no-income-tax people much more.

Another argument I've heard against allowing the sales tax optional deduction is ... wait for it ... you can predict this one ... say it with me now ... "IT ONLY HELPS THE RICH."  This argument is based on the fact that you have to itemize your deductions in order to benefit from this deduction.  However, this isn't an effective argument against this particular deduction at all;  It's an argument against the use of the itemized deductions in general.  If people don't like deductions that can only be taken if the taxpayer itemizes, than they should be fighting for the repeal of the itemized deduction rule as a whole.  However, if they cede that itemized deductions in general are sound tax policy, I find it quite hypocritical to argue that individual itemized deductions shouldn't be allowed because non-itemizers can't use them.  This argument is so obviously flawed that I suspect those that promote are really just trying to sway long-term public opinion against itemized deductions as a whole and don't really expect many people to be persuaded on this specific issue.

The other problem with the "It only helps the rich" argument is that it ain't so. The only evidence I've heard in support of this argument is that only something like 25% of taxpayers itemize.   This argument assumes though that everyone who can itemize actually does so.  I seriously doubt that this is so.  The three basic components of itemized deductions are taxes, mortgage interest, and contributions.  In practical terms, what this means is that pretty much everyone who makes enough to pay state income taxes and has a mortgage on their house can itemize.   (Not only that, but even people who don't have a mortgage can often itemize if they have large medical bills.)

I did a quick search and couldn't come up with an estimate of the number of people carrying home mortgages in the US, but I suspect it's higher than 25%.  What could explain people not itemizing if they can?  Well, some people are just sure they don't have enough deductions to matter and some don't want to deal with hassle.  I've seen a few people who won't collect the data to itemize no matter how I try to convince them.  It's true that these people won't be helped by the new law, but that's not the fault of the law.

This argument also overlooks the fact that middle class people who pay sales taxes, but little  state income taxes may suddenly discover that they can if they choose to deduct the sales taxes.  Furthermore, it overlooks the fact that some people may choose to deduct sales taxes even if their income taxes are higher.  Why would they do this?  Well, if you deduct the income taxes this year, you have to include your state tax refund in next year's income.  However, if you deduct the sales taxes, your income tax refund isn't taxable.  I've already had several people who have done this year.  On average, people who made this choice are going to save three times as much taxes next year as they're electing to pay extra this year.  That's pretty significant.

Bottom line?  Well, I've already had several people this year who have benefited from the sales tax deduction and not one of them makes more than $65,000 a year.  Most of them made significantly less than that.  I realize that that's anecdotal evidence, but I suspect it's going to project pretty well.  Most people just aren't going to keep and track every receipt every year unless they know they'll have a huge amount of sales taxes for the year. (Example: They're building a house.)  That means they're going to have to use the tables and the tables are not exactly generous.  The result is that the majority of people using the sales tax deduction are those in states with no income tax, or who pay little or no income tax for the year.

So, do I think the sales tax deduction is beneficial to middle-income taxpayers?  Yes, it certainly can be.  Do I support the current law? No.  I find the arguments that I've heard unpersuasive.  However, as I mentioned, the optional sales tax deduction switches the tax advantage to those states with no income tax.  I believe that the law should be revised to allow both sales and income tax deductions.

Yeah, I know this has really rambled, but I've been writing with sleep deprivation and a headache.  I just hope it makes sense.

Comments

[sarahk]

yeah, my eyes glazed over after scanning for the number of times "tax" or a form thereof is mentioned. way too many. me no read. :D