Federal Deduction for State and Local Taxes Primarily Benefits Wealthy Families

A central takeaway from Who Pays Taxes in California?, our recently released report on the state’s tax system, is that the lowest-income families pay a larger share of their incomes in state and local taxes than other families. This is partly due to the fact that high-income families disproportionately benefit from tax breaks, and especially notable among these is the federal deduction for state and local taxes. Families can reduce their taxable income for federal income tax purposes by deducting from it the amount they pay in some state and local taxes, though this doesn’t reduce state or local revenues.

Even without accounting for this federal deduction, families in the lowest fifth, with an average annual income of $13,900, pay a greater share of their incomes on average in state and local taxes (10.6 percent) than all but the wealthiest 1 percent of Californians (11.2 percent), who earn an average of $2.0 million annually. These tax and income figures come from the Institute on Taxation and Economic Policy. Once federal deductability is factored in, the average share of income paid in state and local taxes drops considerably for families at the upper end, including a 2.6 percentage-point decline among the top 1 percent. As a result, the bottom fifth and the second fifth, on average, each pay larger shares of income in state and local state taxes (10.5 percent and 9.0 percent, respectively), than do all other segments, even the top 1 percent (8.7 percent). The interactive graphic below shows the impact of federal deductability on state and local taxes paid across the income distribution.

 

These figures include the effect of Proposition 30’s tax rate increases. California voters approved Proposition 30 in November 2012, raising the state sales tax rate through 2016 and personal income tax rates on high-income taxpayers through 2018. These income tax rate increases almost exclusively affect the top 1 percent of Californians. So, if Proposition 30’s tax rate increases are allowed to expire in 2018, not only would it significantly hurt the level of services California could support, but the disparity between what those at the bottom and top of the income distribution pay in state and local taxes would be even greater.

In the coming months, the debate will be gearing up over how to ensure California’s tax system raises sufficient revenue to support the key public systems and services that underpin a strong economy and a high quality of life for all Californians. Policymakers and other stakeholders should bear in mind that low-income families now contribute disproportionately to state and local taxes and that there are specific policy choices, such as enacting a state Earned Income Tax Credit, by which the state could help those still struggling in the long recovery from the Great Recession.

— William Chen