Federal Deductibility Is Distorting Tax Liability in Six States

At the federal level, the state and local tax (SALT) deduction has emerged as a hot-button political issue ever since the deduction was capped at $10,000 under the Tax Cuts and Jobs Act (TCJA) of 2017. The SALT deduction has defenders as well as detractors, but a peculiar inversion of it—a state deduction for federal taxes paid—exists in only six states. Despite the best of intentions, it is bad news for taxpayers. Fortunately, three states are on track to eliminate the policy within the next few years. The other three should join them.

Alabama,[1] Iowa,[2] and Louisiana[3] offer full policies of federal deductibility under their individual (and, in Alabama and Louisiana, corporate) income taxes, while Missouri,[4] Montana,[5] and Oregon[6] provide the deduction exclusively for individual income taxpayers and cap the benefit. Additionally, Missouri and Oregon phase out the deduction entirely for high earners.

But the deduction’s days may be numbered. Louisiana voters have an opportunity to ratify a measure that would replace federal deductibility with lower statutory tax rates when they go to the polls on November 13.[7] Elsewhere, Iowa tax reforms adopted in 2018 as revenue-contingent[8] and then confirmed in 2021 will see repeal of federal deductibility, replaced by lower rates, in 2023,[9] and a tax simplification package adopted in Montana in 2021 will repeal federal deductibility as of 2024.[10]

Should Louisiana voters approve the reform, that would leave Alabama with the only unfettered policy of federal deductibility, and two other states with partial deductibility.

The intentions behind federal deductibility are undoubtedly pro-taxpayer. Policymakers wanted to avoid a tax on a tax, so they allowed taxpayers to deduct their federal tax liability in calculating state liability in the same way that the federal government has allowed taxpayers to deduct their federal liability. (The implementation of these provisions avoids circularity.) There is reason to believe this concern is misdirected, but most taxpayers would not argue with the intended result of lowering their state tax liability.

Unfortunately, that is not what happens in practice. Tax liability is not reduced. It is distorted.

The anachronistic state policy of federal deductibility ties states’ tax codes to federal policy in unexpected and often undesirable ways. When federal taxes go down, state taxes go up. When the federal government provides preferential treatment of something—from the child tax credit to research incentives—states with federal deductibility penalize it.

This unintentionally perverse arrangement even threatened to ensnare the rebate checks provided under the Coronavirus Aid, Relief, and Economic Security (CARES) Act since they were structured as an advance on a one-time tax credit, and thus reduced federal tax liability.[11] The affected states, none of which wished to tax COVID-19 relief checks, generally acted to avoid doing so, but the averted tax hit was just one particularly salient example of a phenomenon that happens every day in the six states with federal deductibility.

The federal deduction tends to be regressive, though not uniformly; it may be more accurate to refer to its effects as chaotic. Still, high earners, because they have higher federal effective tax rates, tend to see their state tax liability reduced the most, while low-income filers, because they have little or no federal tax liability, get scant benefit from the deduction. The result, applied to the graduated rate structures in all six of these states, is not a flatter tax, just a more distorted one.

Few would argue that every deduction, credit, exemption, or other preference in the federal tax code is good or desirable, but it would be even more difficult to argue that we would be better off with the inverse treatment. Federal deductibility is like a funhouse mirror, inverting and distorting the federal code in ways that fail to achieve the state’s policy goals. It increases state tax liability when small businesses invest, when families have children or adopt, or when people give to charity. Federal deductions for education or health-care expenses are partially offset by higher state taxes, and part of the benefit of tax-advantaged investments like IRAs is eroded because states with federal deductibility boost a taxpayer’s liability when their federal tax burden declines.

Federal deductibility also ties states to federal tax rates, and not just federal tax bases. Conformity with the federal tax code is generally a good thing, promoting certainty and simplicity for taxpayers and tax administrators alike. But states tend not to follow federal rates, to say nothing of creating an inverse relation with them. There is no reason why a federal tax cut should result in an unlegislated state tax increase, nor why higher federal taxes should deprive states of revenue. Changes in state revenue potential of this nature should be the prerogative of lawmakers, not the consequence of a policy like federal deductibility.

Repealing federal deductibility is a bipartisan priority. In Iowa, it is part of a Republican-led tax reform package, while in Louisiana, it features in bipartisan reforms, and the liberal Institute on Taxation and Economic Policy (ITEP) has long called for the deduction’s elimination, albeit not necessarily in a revenue-neutral fashion.[12]

Simply repealing federal deductibility is, unequivocally, a tax increase. States should not see the elimination of this inadvertently perverse policy as a revenue raiser. Instead, they should replace this well-intended but ineffectual policy with something better, and easier to understand: lower tax rates.

Imagine a single taxpayer with $50,000 in taxable income (pre-federal deduction) and federal income tax liability of $6,748. In a state without federal deductibility, a 5 percent flat-rate tax would generate $2,500 from them. With federal deductibility, however, the rate would have to be 5.78 percent to raise the same amount from this filer. Taxpayers would be better off with the lower rate, which is neutral in its application, compared to the distorted incentives of federal deductibility.

In Alabama and Louisiana, federal deductibility is available under the corporate income tax as well. This was also true of Iowa until recently, but while repeal of the provision for individuals was predicated on future revenues, the tax reforms of 2018 eliminated the deduction for corporate taxpayers immediately. Similar inversions of incentives occur here. The depreciation of assets yields higher state tax liability. State corporate taxes go up when a company carries forward losses or takes advantage of research and development incentives, while declining when federal tax liability rises, for instance if more of a multinational corporation’s activity is taxed under the Global Intangible Low-Taxed Income (GILTI) provisions of federal law.

Caps on federal deductibility limit the pernicious effects of the deduction, but it still causes unnecessary distortions while adding to the complexity of state tax codes. With Iowa, Louisiana, and Montana eyeing futures without federal deductibility, and Missouri as of 2018 adopting its high earner phaseout, the time may have come to clear this deadwood out of state tax codes altogether.

Louisiana voters can lock in this momentum at the polls on November 13th, replacing their current system of federal deductibility and a top rate of 6 percent with a simpler tax code with an admirably low top rate of 4.25 percent, allowing the “sticker price” of the state’s income tax to better reflect real tax burdens even as it eliminates the distortions created by federal deductibility. And policymakers in Alabama, which would then be the last state with an uncapped deduction, as well as in Missouri and Oregon, should prioritize ending this anachronistic policy.

In Alabama, the only state where a constitutional amendment would be necessary to repeal federal deductibility, the elimination of deductibility for all taxpayers would best be offset by a commensurate across-the-board rate cut. In Missouri and Oregon, where the provision is much smaller and does not substantially benefit high earners, even if it is simultaneously very poor at providing meaningful and intelligible relief to low earners, the best approach would either be to reduce rates in the bottom brackets or to increase the standard deduction.

Through such reforms, policymakers can take the pro-taxpayer intentions behind the ill-considered deduction and turn them into reality.

[1] Ala.Const. Art. XI, § 211.03-04.

[2] I.C.A. § 422.7.

[3] La. Rev. Stat. § 47:55 and -293.

[4] V.A.M.S. § 143.171.

[5] MCA § 15-30-2131(1)(b).

[6] O.R.S. § 316.680(b).

[7] Janelle Cammenga, “Louisiana Voters Have Chance to Simplify Taxes and Lower Burdens,” Tax Foundation, Oct. 21, 2021, https://www.taxfoundation.org/louisiana-election-results-tax-ballot-measures/.

[8] Jared Walczak, “What’s in the Iowa Tax Reform Package,” Tax Foundation, May 9, 2018, https://www.taxfoundation.org/whats-iowa-tax-reform-package/.

[9] Iowa S.F. 619 (2021).

[10] Montana S.B. 399 (2021).

[11] Jared Walczak, “These States Could Tax Your Recovery Rebates,” Tax Foundation, Apr. 8, 2020, https://www.taxfoundation.org/cares-act-rebate-state-tax-rebate/.

[12] Dylan Grundman O’Neill, “Why States That Offer the Deduction for Federal Income Taxes Paid Get It Wrong,” Institute on Taxation and Economic Policy, May 1, 2017, https://itep.org/why-states-that-offer-the-deduction-for-federal-income-taxes-paid-get-it-wrong-2/.