The federal government must reduce the deficit to arrest its unsustainable debt trends. How might this affect state and local governments? This issue brief considers the case of capping itemized deductions, a tax-reform proposal supported by Democrats as well as Republicans. While the impact would be more indirect than, for example, cuts to federal grants-in-aid programs, the pain to state and local governments could still be significant.
Hardest-hit will be New York, New Jersey, California, and other so-called blue states known for their high taxes, high costs, extensive public services, and large public-sector workforces. Current federal tax policy benefits blue-state taxpayers disproportionately. The home mortgage-interest deduction subsidizes their high home values, and the deduction for state and local taxes paid provides relief from their high tax burdens. Because incomes are higher in blue states, their taxpayers make use of itemized deductions at a much higher rate than in other states.
But this may all be coming to an end. In the near term, capping deductions would dramatically raise taxes on high earners, soften home prices, and call into question the ultimate sustainability of the blue-state model. However, in the longer term, such caps could simply cause blue states to shift toward a more nonblue model of lower taxes, lower spending levels, and greater reliance on economic growth to expand the tax base.