With the federal debt at an all-time high and policy makers wanting to broaden the tax base in exchange for lower marginal tax rates, legislators continuously look at tax reform, specifically, deductions for mortgage interest, state and local taxes, and charitable contributions, to serve their purposes. For decades there has been much debate about the possibility of eliminating certain state and local taxes, to include state and local income taxes, real estate and personal property taxes, and general sales taxes. While at a quick glance we see that these eliminations could reap great monetary benefits for the federal government, a closer look will reveal that there is more at stake than just the revenue gained. This paper examines the ways different constituents are affected by the deductibility of real estate property taxes and whether eliminating this tax provision is a viable option.
The Revenue Act of 1913 was enacted during Wilson's presidency, and created the first federal income tax, substantially replacing the revenue that was being acquired from tariffs with revenue acquired by taxing an individual's income. The Revenue Act of 1913 allowed itemized deductions for taxes paid, to include almost any tax paid during the year.
In 1944, the standard deduction was introduced in the Individual Tax Act, as income taxes were becoming more standard for everyone, instead of only the wealthy. It offered a tax break to those middle and lower class taxpayers who did not have substantial deductions to itemize. Itemized deductions grew between 1947 and 1979 and included deductions for items such as state and local taxes, certain interest paid, charitable contributions, and special health expenses. The revenue gained from these itemized deductions was diminished somewhat by the also growing standard deduction, because taxpayers were benefiting more from the amount received in the standard deduction than what they received when they itemized. In 1986, the Tax Reform Act of 1986 (TRA86) was introduced, which eliminated or amended some of the tax deductions, including the temporary elimination of the state and local sales tax deduction and restrictions on the home mortgage interest deduction (CBO, 2008).
BENEFICIARIES OF THE PROPERTY TAX DEDUCTION
Currently the Internal Revenue Service allows an individual to deduct taxes paid for real estate and personal property. The amount a taxpayer saves in federal taxes is found by multiplying the amount being deducted by their marginal tax rate. Maguire & Stupak (2015) noted that there is a strong correlation between individuals with higher income and property ownership with greater values, as well as higher income correlating with higher tax brackets. This means the amount of taxes a taxpayer pays on their property will be higher because of progressive state taxes, allowing them a larger deduction, which is then multiplied by a higher marginal tax rate, resulting in more of a tax savings than those with lower incomes. However, for incomes over $200,000, the tax savings decline because those taxpayers are subject to the Alternative Minimum Tax (AMT), which disallows the property tax deduction.
In order to take advantage of these deductions, the taxpayer must itemize their deductions, rather than take the standard deduction. They would only itemize if they can claim enough deductions for the itemization to be higher than the standard deduction, and this also usually applies to those in the higher income ranges. As shown in Table 1, when the adjusted gross income range is between $0 and $25,000, the percent of taxpayers itemizing is less than 10%. Between $25,000 and $50,000, the percent of taxpayers increases to between 13% and 30%. Between $50,000 and $100,000, about 50% of taxpayers itemize. Finally, just under 80% of all taxpayers who make over $100,000 itemize their deductions, with that percentage increasing substantially as the AGI increases (Statistics, 2013). Clearly, the real estate property tax deduction disproportionately benefits high-income taxpayers at the expense of low-income taxpayers (Lundeen, 2013).
PROPERTY TAX IMPACT ON VARIOUS CONSTITUENTS
A report prepared by the Joint Committee on Taxation defines tax expenditures as revenue losses attributable to provisions of the federal tax laws which allow a special exclusion, exemption, or deduction from gross income, or which provide a special credit, a preferential rate of tax, or a deferral of tax liability. Tax expenditures include any reduction in income tax liabilities (Joint, 2013). Toder et al. (2013) identified the top five permanent tax expenditures for owner-occupied housing. Listed at number three was the deductibility of state and local property taxes at $30.6 billion (based on the 2010 federal budget).
State and local taxes, including property taxes, are one of the biggest deductions taken by taxpayers. According to the Joint Committee on Taxation (2014), $182 billion will be lost revenue between 2014 and 2018 due to property tax deductions. Not taking into consideration the other effects that might come into play, such as behavior changes or a rise in the use of other non-deductible taxes and fees, this is a large amount that policy makers often use to promote the repeal of property tax deductions.
Feldstein & Metcalf (1987), however, argue that the actual amount of gained revenue from eliminating state and local tax deductions could be lower than what is estimated. When taxpayers are allowed to deduct taxes paid from their adjusted gross income, they develop the perception that the cost of their property is lower. It is possible that eliminating a tax deduction at the federal level could cause taxpayers to change their spending habits in ways that would lower the amount of taxes they pay on their property in order to achieve the same lower cost. If state and local governments aren't raising enough revenue through the property taxes, they will turn to financing their spending with non-deductible taxes and fees. Many of these non-deductible taxes and fees come from higher taxes and fees to corporations, which have a larger impact on federal revenue than individual income taxes. This means that...