State taxes are deducted from federal filings, moots the progressive effect

The first reason is that deductibility itself blunts the effect of subnational redistribution. The reason, of course, is that where federal marginal tax rates increase with income, federal deductibility makes effective-that is, after-tax-state and local average tax rates less progressive. Thus, for example, a state flat-rate income tax is actually regressive in the presence of federal deductibility and progressive federal marginal tax rates." Similarly, progressive state income tax rates are made less progressive by the federal SALT deduction. This point is obvious enough, but a brief example will help to clarify. Consider an income tax imposed by the State of Michiana, which has three residents: A, B, and C. If the federal subsidy rates for these three taxpayers are 0 percent, 20 percent and 50 percent, respectively, then the effective progressivity of the state's income tax will be reduced in the manner illustrated below:

As these figures demonstrate, the statutory tax burden is substantially more dispersed than the effective tax burden. Moreover, it should be clear that the magnitude of this difference in dispersion is a function of how steeply progressive the federal income tax is. Thus, as federal income tax rates become more progressive, effective state tax progressivity declines even further. For example, if Taxpayer C above faced a federal subsidy rate of 60 percent, his effective state tax burden would be 40, equal to that of Taxpayer B. One might conclude, therefore, that the federal deduction for state and local taxes actually works to minimize the (potentially) deleterious effect of progressivity, rather than to eliminate it, because the federal government effectively shares in the cost of subnational progressivity to high-income taxpayers.

In considering the efficiency consequences of subnational redistribution, however, what matters is not the absolute level of redistribution undertaken by any one jurisdiction, but rather the relative effect of redistribution. For any given state tax burden, deductibility has no effect on the relative disadvantage of redistribution as compared to benefit taxation. Consider, for example, another jurisdiction where Taxpayers X, Y, and Z each pay $100 and receive the same amount of public goods. Assuming that Taxpayer C above consumes an amount of public goods less than his $100 share of the tax burden-say, $60-he faces the same incentive to migrate with or without the deduction. In both cases the potential "payoff" from migrating is the $40 increment in public goods to be had by joining X, Y, and Z. The reason, of course, is that the deduction promises to reduce C's tax burden from $100 (statutory) to $50 (effective) regardless of the amount of services that he 132 consumes