Deduction ensures that state taxes remain regressive

As the devolution of fiscal responsibilities to state and local governments continues over the next several years, questions regarding how best to coordinate national and subnational fiscal policies will assume greater significance. As I have argued above, the federal income tax deduction for state and local taxes is at the heart of the field of fiscal federalism, bringing together questions of subnational redistribution and tax design in a multiunit system of governments. Yet the current approach for addressing these issues in federal tax law, codified in section 164, fails to reflect properly the normative concerns of fiscal federalism. As currently structured, this SALT deduction is a highly regressive federal subsidy that operates to encourage states and local governments to adopt progressive tax systems. This progressivity bias in federal tax law is exactly backwards. A restructured federal SALT subsidy, based on the design principle of distributional neutrality as outlined above, would eliminate the unnecessary distortions and inefficiencies created by the current system. To be sure, by removing the current incentives for state and local governments to impose a greater tax burden on high-income, high-wealth taxpayers, this change would also likely result in less progressive state and local tax systems. At the same time, however, a distributionally neutral SALT subsidy would alter the distribution of the federal income tax burden, making it more progressive. This outcome-a more progressive federal tax structure and a less progressive state and local tax structure-is more consistent than current law with basic principles of fiscal federalism.