Question

Although the government from the state to the local level is clearly unitary, local finance is very diverse, with many local levies and revenue streams. Should states abolish all local taxes and institute more efficient tax reforms? Why/why not?

Answer 1

Under federal tax law, individuals can deduct from their total income when filing their federal taxes the income and property taxes they pay to their state and local governments, as well as any interest they earn from state-owned or local bonds. Individuals have been allowed to deduct their income tax or sales taxes in recent years Since federal tax deductions effectively spread the cost of such deductions across all taxpayers in the form of higher federal tax rates, state and local tax deductions result in federal taxpayers subsidizing taxpayers in high-tax, high-debt states in low-tax, low-debt states. As a result of these deductions, distributional impacts within states lead to low-income residents subsidizing high-income residents.

When exemptions from state and local taxes and bonds were withdrawn, federal income tax rates could be lowered by as much as 16.4%. Ending federal state and local tax and debt payments would help improve state and local government fiscal discipline and economic efficiency as taxpayers would no longer be reimbursed for some of the taxes they paid to their state or locality. Instead, the full cost of the services they rendered would be charged. In fact, municipal bond holders would no longer receive a dividend in addition to the interest earned from their municipal bonds, and government and local budgets would have to represent the full cost of any accumulated debt

Tax deductions reduce the tax base so that higher marginal tax rates are required to maintain the same level of tax revenue. Ideally, deductions should be kept to a minimum after the creation of the appropriate tax base. But many deductions and exceptions are littered with the U.S. tax code. The federal state and local tax and municipal bond interest deductions turn high-tax and high-debt states and high-income taxpayers into those special interests. Since state and local taxes reduce the after-tax income of people, it may make sense to exclude from federal taxation the income used to pay those taxes. But this was when the majority of services were provided by state and local governments and most taxes were collected. The reverse is true today, as the federal government earns more than 50% more revenue than the combined government and local governments.

As the sole collector of revenue, no tax clevel should be excluded by the federal government. By fact, the tax deduction allows states to raise taxes higher than they would otherwise, which helps governments to provide services that are left to the private sector more adequately. The tax deduction also has major adverse effects on the distribution of income from the poor to the rich and from people in low-tax states to people in high-tax countries