Federal fairness to state taxpayers: irrationality, unfunded mandates, and the "salt" deduction.

• Author: Galle, Brian

By sheer dollars alone, the largest impact of the Alternative Minimum Tax is to deny many taxpayers the deduction for the taxes they paid to their state and local governments under [section] 164 of the Internal Revenue Code. This Article provides a fine-grained analysis of the overall fairness of the state-and-local-tax deduction--and, by implication, the fairness of its partial repeal through the Alternative Minimum Tax. I offer for the first time a close examination of how newly understood limits on taxpayer mobility and rationality might affect individuals' choices of bundles of local taxes and local-government services, which in turn informs our assessment of the "fairness" of those exchanges. Many of these lessons can be generalized to consumer choices more generally. In addition, I track the reciprocal benefits and burdens that flow between the national government and local governments--again, although the influx or outgo of billions of dollars surely affects how the federal tax system should account for the outputs of local government, scholars have neglected that question. Finally, I note that [section] 164, and therefore the Alternative Minimum Tax, can have serious effects on federal-state relations, such that the debate over both provisions is in many ways a debate not only over fairness but also about federalism.

TABLE OF CONTENTS INTRODUCTION I. BACKGROUND II. EQUITY AND COGNITIVE BIASES A. Do People Make Good Choices? B. Policy Responses to Uncertainty III. MORE ON MOBILITY IV. EFFECTS OF FEDERAL MANDATES A. State Spending B ... And Getting V. FAIRNESS IN TAX VS. FAIRNESS IN GOVERNMENT? VI. BEYOND SUBJECTIVE WELL-BEING? CONCLUSION INTRODUCTION

This Article is about a single provision of the U.S. Tax Code--[section] 164, the deduction for state and local taxes paid ("SALT"). In the tradition of many an introductory tax course, I look through the keyhole of the SALT deduction into some of the deeper mysteries of tax theory. In particular, by evaluating the fairness of [section] 164, I illustrate the difficulties of relying on utilitarian or welfare theory as a guide to tax policy, I also draw out some novel connections between the Internal Revenue Code and the relationship between the states and the federal government.

The SALT deduction has risen to prominence with the increasing significance of the Alternative Minimum Tax ("AMT"). The AMT is likely the most important practical tax issue facing individual Americans today. (1) In a few short years, the cost of repealing the AMT will exceed the cost of repealing the rest of the individual income tax. (2) As of this writing, AMT reform is the leading tax goal, and one of the top overall legislative priorities, for the Democratic majority in both houses. (3) Although the politics and impressive budget numbers of the AMT have gotten much ink, few have discussed the AMT from the perspective of tax theory. The vast bulk of taxpayers affected by the AMT fall into its grasp because it prevents them from claiming deductions to which they would otherwise be entitled, particularly deductions for taxes paid to state and local governments. (4) One way to theorize the AMT, then, is as the sum of these constituent parts. (5)

The SALT deduction is perhaps the most theoretically imposing component of the AMT. Debate over the SALT deduction is not new. Prior analyses, however, have made two major assumptions that render them rather suspect. First, they have assumed that taxpayers respond to financial incentives, such as their local tax systems, in a way that is wholly rational. Second, they have assumed (at times for the sake of simplicity) that the states' receipt of billions of dollars in federal grants and federally imposed burdens do not affect state and local taxing and spending decisions, a proposition that is clearly untrue. What I add here is a fine-grained analysis of the deduction once these assumptions are removed.

To begin, it is useful to understand the scope of the deduction and its historic rationales. Commentators over the years have urged Congress to grant taxpayers a deduction for the taxes they pay to their state and local governments. (6) Proponents have said that the deduction is necessary to treat fairly taxpayers hailing from jurisdictions that impose different taxes. (7) The argument has succeeded. The annual budget cost of [section] 164--the provision providing individuals and corporations with a deduction for the state and local income, property, and (in some instances) sales taxes they pay--totaled about $75 billion in one recent counting. (8) Yet the provision remains controversial, with some prominent calls--including from the President's Advisory Panel on Tax Reform--for its repeal. (9)

When proponents say that the deduction is necessary to treat taxpayers fairly, they mean to invoke one of the basic norms of the tax system, the notion of horizontal equity--the claim that the tax system should treat similarly situated taxpayers similarly. (10) Under the traditional view of [section] 164, two people who make the same amount of money are not equal if one pays more state tax than the other. (11) Thus the federal tax system should favor the higher state-tax payer. Later critics argued that this was considering only half the apple (or half the orange): state taxes generate services, which increase taxpayer well-being. (12) So, the critics said, the higher tax payer, like a consumer who buys a product at retail, has less money in her pocket at the end of the year but is just as well-off as the taxpayer with more money but fewer services. (13) Further analysis by Harvard's Louis Kaplow showed that the equity question might turn on complicated empirical questions of who truly bore the burden of a given state tax--was it true, in other words, that taxpayers got everything they paid for? (14)

This Article argues that the analyses both of Kaplow and the literature he critiques are incomplete. First, both sides of the horizontal-equity debate have so far assumed that an individual's subjective well-being is best measured by the choices she makes in the marketplace. An increasing body of literature, however, shows that we often make choices as a result of our misperception of what would best satisfy our own preferences. (15) Cognitive biases also limit our ability to process market information accurately. (16) These biases undermine a key assumption of the equity critique of the deduction--that taxpayers are able to freely align themselves in jurisdictions where tax levels match their preference for services. States may play on these biases in order to export the costs of their own services onto their neighbors.

Further, the equity critique so far has neglected the relationship between the states and the federal government. States often must pay to comply with federal mandates; they also receive grants from Congress, some subject to costly conditions. In theory, an imbalance one way or the other between what a state receives and what it must expend might be the basis for an inclusion or deduction. As I show, however, it proves exceedingly difficult to find any administrable metric to sort unwanted costs from desired services, interstate bribes, or regulations that have bite only on paper.

These conclusions have significant implications for ongoing policy debates, especially those concerning the AMT. For example, they may (depending on as yet unmeasured empirical data) undermine some of the President's Advisory Panel's arguments for eliminating [section] 164. That suggests, in turn, that we should take more seriously the call for AMT "reform," at least to the extent that we want to prevent the AMT from further eroding the SALT deduction.

The SALT deduction also has very significant effects on the relationship between the states and the federal government. I have detailed elsewhere some of the deduction's consequences at the level of state and local government. (17) I explain here how the choice of whether or not to allow the deduction may have the effect of shifting power to or away from the federal government. Economists have described (although lawyers have generally not noticed) how the SALT deduction permits larger state spending, and might arguably reduce federal spending. But deductibility has additional consequences when combined with federal power to attach conditions to federal grants. That power often serves as a tool for allowing states to negotiate with one another to reduce collective-action costs. Deductibility sometimes raises the costs of these negotiations, an outcome that is more or less attractive depending on how highly we value state diversity. Thus the AMT, by way of its influence on the SALT deduction, may have a hidden impact on federal--state fiscal relations. We must first judge how we feel about those relations before we judge this aspect of the AMT.

Part I of this Article sets out in more detail the mechanics, history, and theoretical underpinnings of [section] 164, explaining that the most basic question we face is whether state and local taxes make local taxpayers better or worse off. Part II recomputes this calculus in light of the fact that taxpayers may often choose their bundle of taxes and services irrationally. Part III similarly suggests some adjustments we must make to obtain taxpayers' desired mix of benefits and burdens in light of what we know about the limits on taxpayer freedom to relocate. Part IV expands our scope to take in federal transfers to and from states. Part V then addresses a residual problem raised by the analysis of Part IV: what should we do if it appears that, in order to be "fair" to taxpayers, we must interfere with the efficiency prescriptions of public-finance economics? Part VI attempts to solve some of the tensions and contradictions of the earlier Parts by reconceiving the notion of equal welfare itself. Perhaps we might reach more satisfying results if we measure not...