Oct 19, 2011 - Middle Class Fairness Act of 2011 would in effect limit SALT deduction, while ...... supply goods to the municipal marketplaceâis certainly the ...
SHANSKE DRAFT
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How Less Can Be More: Using the Federal Income Tax To Stabilize State and Local Finance Virginia Tax Review, Forthcoming Darien ShanskeFNa1 Abstract Governments at all levels - federal, state and local – are suffering through ever more severe budget crises. The interests of these different levels of government are often assumed to be in conflict. For instance, it seems reasonable to believe that if the federal government were to get its finances in order then that would mean less aid to the states. Yet this common assumption is not necessarily correct; what if the federal government saved money through cutting subsidies that are likely doing more harm than good? Currently, the Internal Revenue Code is doling out more than one hundred billion dollars per year in just such subsidies to the states. If these subsidies were cut completely, then this alone would go a long way towards resolving the disputes that are now regularly threatening to bring the federal government to a standstill. This Article advocates deep cuts, but not the complete elimination of these subsidies because much smaller subsidies could be better focused on enhancing state and local fiscal stability, and this would mean that the federal government would be spending less while aiding the states more. Most centrally, this Article advocates that the
FNa1
Associate Professor of Law, University of California, Hastings College of the Law. Thanks to Ben Depoorter, David Gamage, Stephanie McMahon, Susie Morse, Lori Raineri, Ted Seto, Kirk Stark, Dennis Ventry, Joan Youngman and all the participants in the 2010 Junior Scholars Tax Workshop, 2011 Critical Tax Conference, 2011 Law and Society Conference, the UC Davis Law Faculty Workshop, and the 2011 Meeting of the National Tax Association. I also want to thank Chuck Marcus for invaluable research assistance. All mistakes are my own. [101]
Electronic copy available at: http://ssrn.com/abstract=1946614
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federal government encourage states to use the local property tax in contrast to more volatile revenue sources.
Electronic copy available at: http://ssrn.com/abstract=1946614
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Table of Contents I. Introduction .................................................................................104 II. The Broader Theory: The Federal Government Should Use the Federal Income Tax to Stabilize Sub-national Public Finance Ex Ante. ...................................................................110 A. Diverse Perspectives on the Proper Role of the Federal Tax System......................................................................111 B. Preliminary Objection.......................................................115 C. The Heart of the Matter: The Federal Interest in Ex Ante Stabilization............................................................116 D. Connection to the Benefit Principle.................................121 III. Background: A Short, Broad, and Tendentious History of the Federal-State Tax Interaction ..........................................125 A. SALT Itself: I.R.C. § 164(a)............................................125 B. Exception for Special Assessments: I.R.C. § 164(c)(1)...126 C. Exclusion for the Interest on State and Local Bonds: I.R.C. § 103.....................................................................127 D. Above the Line Deduction for Real Property Taxes: I.R.C. § 63(c)(1)(C) ........................................................128 E. Build America Bonds: I.R.C. § 54AA .............................129 F. A Tangled History ............................................................131 G. History and Salience: How to Proceed Prudently............137 IV. The Reform Proposal.................................................................142 A. Outline of Proposed Reforms ..........................................142 1. Make the property tax primus inter pares ..................142 2. Better manage the federal financing subsidy. .............143 B. Justifying the Reforms .....................................................144 1. Stability .......................................................................144 2. Efficiency....................................................................148 a. Whither Jurisdictional Competition (the Tiebout Model)? .......................................................................151 b. Conclusion on Efficiency ..............................................154
3. Equity.........................................................................154 a. An Objection .................................................................157 V. Refining the Reforms, Including a Proposal for Property Tax Withholding ...........................................................................159 A. How Much Impact Can Federal Tax Policy Have? ..163 VI. Conclusion.................................................................................166
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I. Introduction The fiscal crisis that is now enveloping the United States federal government has been long foretold; so too the crises overwhelming the states.1 These overlapping – and seemingly perennial - crises have spurred many calls for reform, including of the tax systems at both the federal2 and state3 levels. A longstanding common, and reasonable, assumption has been that if the federal government saves money through cutting its subsidies to the states then this will heighten the crisis in the states.4 In this Article I argue that this common fear is exaggerated because the tax subsidies I identify do more harm than good. The reforms proposed in this Article will save the federal government billions of dollars while also helping the states improve their revenue systems. These reforms require little institutional design and are consistent with our best theories of fiscal federalism. What specifically should be reformed? The federal income tax allows (some) taxpayers to deduct (some) of their state and local taxes; this is the State and Local Tax (SALT) deduction of I.R.C. § 164. Despite the parenthetical qualifications, this deduction is
1
See, e.g., DAN N. SHAVIRO, TAXES, SPENDING, AND THE U.S. GOVERNMENT'S MARCH TOWARD BANKRUPTCY (2007); RANDALL G. HOLCOMBE & RUSSELL S. SOBEL, GROWTH AND VARIABILITY IN STATE TAX REVENUE: AN ANATOMY OF STATE FISCAL CRISES (1997). 2 See, e.g., THE NATIONAL COMMISSION ON FISCAL RESPONSIBILITY AND REFORM, THE MOMENT OF TRUTH 28 (2010), available at http://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/The MomentofTruth12_1_2010.pdf. 3 See, e.g., CALIFORNIA COMMISSION ON THE 21ST CENTURY ECONOMY, FINAL REPORT (2009), available at http://www.cotce.ca.gov/documents/reports/documents/Commission_on_the_21st_ Century_Economy-Final_Report.pdf. 4 See, e.g., JEFFREY H BIRNBAUM & ALAN S. MURRAY, SHOWDOWN AT GUCCI GULCH 113-14 (1987) (account of successful argument made in the 1980s by states against cutting federal tax subsidies); Billy Hamilton, A Trillion Here and a Trillion There: States Face the Federal Budget Knife, 62 STATE TAX NOTES 115 (Oct. 10, 2011); Adam Nagourney & Michael Cooper, Wary State and Local Lawmakers Try to Gauge Impact of Deficit Deal, NEW YORK TIMES, Aug. 2, 2011, at A15.
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estimated to have cost the federal fisc almost $75 billion in 2009.5 In addition, investors in state and local bonds have the interest they earn excluded from federal income tax, primarily under I.R.C. § 103, for an annual total cost to the federal government of at least $40 billion per year.6 Eliminating these poorly-designed tax expenditures relating to state and local government7 could therefore save over one hundred billion dollars per year or one trillion dollars over ten years. To put this potential savings in context, this summer the federal government struggled to find $2.4 trillion dollars in savings over ten years.8 It only found one trillion, and so Congress is spending the fall of 2011 desperately searching for another trillion or so in savings, which is about what can be saved just by eliminating the poorly identified pieces of the tax code identified in this Article.9 Furthermore, the stimulus plan of 2009 directed at least $223 billion to states and local governments.10 If the focused use of the federal subsidy proposed
5
See JOINT COMM. ON TAXATION (JCT), ESTIMATES OF FEDERAL TAX EXPENDITURES FOR FISCAL YEARS 2009-2013 at 49, 50 (Jan. 11, 2010). 6 CONGRESSIONAL BUDGET OFFICE, THE DEDUCTIBILITY OF STATE AND LOCAL TAXES 4 (Feb. 2008) (aggregating bond programs); JCT, supra note 5, at 46 ($3 billion annual estimate for two years of Build America Bonds program). All of these numbers are the product of numerous contestable assumptions; this Article will rely on them nonetheless as the best estimates that we have because 1) this Article is not the place to engage in the lengthy debate as to how to calculate these counterfactual figures and 2) as to the figures at issue in this Article, the figures strike the author as reasonable. 7 “Tax expenditures” are defined by statute as “revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability.” Congressional Budget and Impoundment Control Act of 1974, Pub. L. No. 93-344), § 3(3). 8 Carl Hulse & Helene Cooper, Leaders Agree On Outlines Of Deal To End Debt Crisis, N.Y. TIMES, Aug. 1, 2011, at A1. 9 Id. Note that I am identifying cuts that make sense from a long-term perspective. Given the state of economy in the fall of 2011, entirely cutting these tax expenditures immediately is probably not advisable. 10 See Robert P. Inman, State Fiscal Distress, 6 FEDERAL RESERVE BANK OF ST. LOUIS: REGIONAL ECONOMIC DEVELOPMENT 65, 75 (2010). Note that Inman does not maintain that the stimulus plan was well designed and concludes that “a better strategy would be to build on the optimal structure of state government finances in normal times.” Id. at 78. Inman does not elaborate on what this structure should
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here obviated the need for even a percentage of this federal intervention then this would be another significant savings. Related reform proposals from both parties have been piecemeal, contradictory to one another and generally ad hoc. Thus, both major deficit reduction commissions recommended cutting some of these tax expenditures last year,11 as have many other commentators and policymakers over the preceding decades – including President Obama in the American Jobs Act of 2011.12 The leading academic treatments of the relationship between the federal and state revenue systems – and there have not been very many13 – provide vital theoretical insights but only limited pragmatic guidance to federal tax policymakers.14 This Article be how or how the federal government might do this; this Article is an attempt to do so. 11 See NATIONAL COMMISSION, supra note 2, at 31 (proposing elimination of tax exemption for state and local bonds); THE DEBT REDUCTION TASK FORCE (BIPARTISAN POLICY CENTER), RESTORING AMERICA’S FUTURE 34 (2010) (proposing eliminating the State and Local Tax (SALT) deduction, noting that this proposal to eliminate the deduction first rose to prominence under the Reagan administration in 1985). 12 American Jobs Act of 2011 § 401 (limiting the SALT deduction and the Section 103 exclusion); GENERAL EXPLANATIONS OF THE ADMINISTRATION’S FISCAL YEAR 2012 REVENUE PROPOSALS 20-21 (proposal for adding tax credit bonds), 131-32 (proposal that would in effect limit the SALT deduction); S. 727, 112th Cong. §§ 106, 111 (2011) (Bipartisan Tax Fairness and Simplification Act of 2011 would eliminate tax exclusion for interest on state and local bonds and replace exclusion with a non-refundable tax credit, but would not create new limit on SALT deduction); H.R. 2495, 112th Cong, §§ 401, 523, 524 (2011) (Tax Equity and Middle Class Fairness Act of 2011 would in effect limit SALT deduction, while also replacing Section 103 exclusion with tax credit bonds). 13 Cf. Brian D. Galle & Jonathan Klick, Recessions And The Social Safety Net: The Alternative Minimum Tax As A Countercyclical Fiscal Stabilizer, 63 STAN. L. REV. 187, 189-90 (2010) (describing the “legal literature exploring stabilization policy at the state level” as “minute” and design of an appropriate federal tax policy as an issue that has been “neglect[ed]”); see also Kirk Stark, The Federal Role in State Tax Reform, 30 VA. TAX REV. 407 (2010) (first article providing key framework). Though both of these related papers begin to address the neglect, neither approach covers the same issues (e.g., neither discuss the Section 103 exclusion) nor arrives at a similar set of proposed “easy” reforms (e.g., reinstating an above the line deduction for only local property taxes). 14 See, e.g., David A. Super, Rethinking Fiscal Federalism, 118 HARV. L. REV. 2544 (2005); Louis Kaplow, Fiscal Federalism and the Deductibility of State and Local Taxes under the Federal Income Tax, 82 VA. L. REV. 413 (1996); Daniel
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begins from these insights and develops a relatively comprehensive analytic rubric that indicates specific cost-saving reforms. There are three reasons that well-wrought federal tax reforms can save the federal government money while providing more help to the states. First, the current system of federal tax subsidies is so disjointed and ill-considered that even minor refinements could yield big savings. Second, state and local tax systems are often so poorly designed that there are many high value/low cost reforms that the federal government can nudge the states to make. Third, the particular reforms I am advocating, and especially the privileging of the local property tax,15 are urgent as states and localities adopt short-term solutions to the current crisis that are likely to make the next one worse, with continued national implications. It is no surprise that property taxes are particularly unpopular in the midst of a real estate driven recession,16 but this understandable political dynamic should not prevent the federal government from trying to rationalize the way that our federal system funds itself. The history of the property tax brings me to the specific observation animating the argument of this Article. During most of the past century, and especially since the passage of Proposition 13 in California in 1978, states have turned excessively away from funding services at the local level with the property tax and have moved instead to using the state-level sales tax and the income tax. The federal government’s role in this shift was minor. Though the federal government did not cause this decline, it can encourage its reversal through a (minor) restructuring of the SALT deduction so as
Shaviro, An Economic And Political Look At Federalism In Taxation, 90 MICH. L. REV. 895 (1992); Clayton P. Gillette, Fiscal Federalism and the Use of Municipal Bond Proceeds, 58 N.Y.U. L. Rev. 1030 (1983). See discussion of previous treatments in Part II.A. infra. 15 By “property tax” I refer to the tax on real property, which is the vast majority of the property tax that is collected. 16 Frank Shafroth, Double Trouble For Property Taxes, 60 STATE TAX NOTES 675, May 31, 2011; Billy Hamilton, Ghost Suburbs and Baby Boomers: An Unhealthy Mix for the Property Tax, 61 STATE TAX NOTES 75 (2011) (noting that long-term demographic trends suggest weakness of property tax base); see also S. 5856, 2011-12 Sess. (N.Y. 2011) (bill passed limiting New York property taxes; Joe Hamel, Group Files Ballot Initiative on Property Tax Cuts, 61 STATE TAX NOTES 13 (2011) (property tax limiting ballot initiative filed in Arizona).
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to make more local property taxes deductible and other state and local taxes less deductible (or not deductible at all).17 The federal government should do this on the grounds of enhancing state fiscal stability, which will concomitantly also advance tax system efficiency and equity.18 As to stability, the property tax base is the most stable tax base.19 The federal government is (properly) a partner to states and localities on a wide range of programs, but the federal government has had to cope with these partners embarking on ever wilder revenue roller coasters.20 Mitigating these revenue swings by ex ante encouraging a more stable tax system would be money well spent. The other state and local taxes, particularly income and sales taxes, are 1) not as politically endangered and 2) not as desirable from the perspective of the theory of tax assignment in a federal system. The federal government has no interest in encouraging the use of these taxes, and the SALT deduction should be reduced accordingly. Yet we need to recognize that there is a danger in further encouraging the use of the property tax; state and local governments are already over-using the federal government’s debt financing subsidy, including for financings secured by property tax revenues. There is no need to attempt to calculate whether it might nevertheless be worth it to encourage the use of the property tax because limiting the federal financing subsidy has long made sense its own. Indeed, with the recent success of the Build America Bonds program (BABs), there is now a model as to how the federal financing subsidy can be wisely reformed so as to encourage better – and hence more stable - state and local borrowing. This reform too would result in savings because currently the subsidy is being disbursed too broadly.
17
How much the federal government can influence state tax policy through the federal income tax is addressed infra Part V.A. 18 Cf. Stark, supra note 13, at 412-16 (federal interest in sub-national stability), 438-39 (stability of property tax). 19 See, e.g., John L. Mikesell & Daniel R. Mullins, State and Local Revenue Yield and Stability in the Great Recession, 55 State Tax Notes (Jan. 25, 2010) at 267, 273 (finding that even during this last recession the property tax was much more stable than any other tax base, particularly the corporate income tax). 20 See, e.g., Super, supra note 14, at 2611-14, 2648-52.
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As for improving economic efficiency, forcing taxpayers, particularly multi-state businesses, to compute taxes in multiple jurisdictions imposes an efficiency loss on our economy even if there is a countervailing gain from the tax competition. Yet the gain from competition need not be counterbalanced by such a great loss from transaction costs. There could be a number of prescribed tax bases and the different states and localities could then compete as to rates, but not the bases.21 Though it would be ideal for there to a whole range of such tax bases, and most especially a national value added tax (VAT) that the states can supplement, the property tax base is a reasonable place to start. After all, like the VAT, there is a significant literature praising the relative economic efficiency of the property tax. To be sure, there are variations in property tax assessment methodology and there is no suggestion that this is going to be the only tax base used by states and localities, but the argument of this Article is that the property tax can expand to replace some of these inferior taxes to the general benefit of all. There is also little argument that the federal financing subsidy could be more efficiently deployed. What of equity, our third axis of possible benefit? Surely we cannot advance equity and efficiency. My equity argument could rely on the proposition that the property tax is progressive, but, as discussed below,22 I do no think that surmise is justified. To foreshadow, I do not think there is, or will be, a strong case that the property tax is either progressive or regressive when considered nationally.23 The heart of the equity argument of this Article is based on the current instability of state revenues: this fiscal instability hurts the most vulnerable the most.24 That is, it is the most vulnerable who 21
Shaviro, supra note 14, at 975, 979-85. See infra Part IV.B.2.a. 23 Making at least part of the SALT deduction an above the line deduction - a proposal of this paper - arguably enhances equity since more lower income people can take the deduction, but only in proportion to their marginal tax rate and only if they own property. The equity argument of the Article cannot therefore rely on this aspect of its proposed reforms. Of course, the administrative ease of making this (sub-optimal) reform is a (weak) equity argument in favor of this Article’s reform proposals. 24 David Scott Gamage, Preventing State Budget Crises: Redefining “Tax Cuts” and “Tax Hikes”, 98 CAL. L. REV. 749, 785 (2010); Super, supra note 14, at 2614, 22
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are liable to have their benefits cut dramatically when unstable revenues plummet in sub-national jurisdictions and it is the most vulnerable who cannot borrow to smooth spending. Of course, the seeming necessity of such cuts might be seen as an argument against hard budget constraints for sub-national governments, but, assuming such constraints, it seems reasonable to assume that the least fortunate will disproportionately benefit from a more stable tax base just as they now suffer disproportionately from an unstable one. This Article proceeds as follows. First, since I am proposing changes to the federal income tax in the name of fiscal federalism, in the next Part (II) I start by explaining why it is appropriate to use the federal income tax to stabilize state and local finances. Part II also explains why previous approaches to the federal income tax as a tool of fiscal federalism have not yielded similarly concrete proposals. Additionally, Part II places the approach of this Article into a broader theoretical framework. In Part III, I briefly consider the history of the tax provisions in question. It will be clear that none of the provisions were the subject of much analysis either before or after enactment; these provisions are proverbial low hanging fruit for serious tax reform. In Part IV, I introduce, in outline, my reform proposals. I then explain in detail why my proposals would enhance the stability, efficiency and equity of our federal system. With these details having been established I return to the proposed reforms in Part V, elaborate upon them and explain why they should be effective. Part VI concludes. II. The Broader Theory: The Federal Government Should Use the Federal Income Tax to Stabilize Sub-national Public Finance Ex Ante.
2632-34. Note that one could also argue, following Kaplow, that since the shift to the property tax is efficiency enhancing then we should make that shift and use the income tax to make the shift distributionally neutral. See generally LOUIS KAPLOW, THE THEORY OF TAXATION AND PUBLIC ECONOMICS (2008). I would be happy with the use of such an expedient but the argument of this paper is that a shift to the property tax enhances equity even before instituting income tax adjustments.
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A. Diverse Perspectives on the Proper Role of the Federal Tax System The two tax expenditures in question are the State and Local Tax (SALT) deduction and the federal financing subsidy. Neither the exact terms of either tax expenditure, nor their interaction with each other, were products of careful thought and study. This undertheorization has been in part addressed by a series of important articles, especially as to the SALT deduction. I will go through these analyses briefly to establish that in their current forms none is adequate to justify the deduction in its current form nor adequate to suggest pragmatic reforms. The principle income tax analysis of the SALT deduction was done by Kaplow in 1996.25 If we are only concerned with making the federal income tax a better income tax, then we should ask whether it is appropriate to allow for the SALT deduction if individuals willingly pay state and local taxes in order to consume goods and services provided by these governments. If these taxes are for a consumption item, then they should not be deductible. We do not let taxpayers deduct the cost of private school tuition, and so why allow a taxpayer to deduct a property tax that is fungible with tuition? One of the recent debt commission reports found just this argument convincing in its argument against the SALT deduction.26 Yet we are not sure which state and local taxes represent such consumption in theory,27 and, in practice, the situation is even more muddled given what it is that taxpayers seem to understand about local taxes.28 We should be wary of reforming the SALT deduction on a hypothesis about the relationship between state and local taxes and private consumption. One might imagine a different justification for the SALT deduction. Stark has noted that the SALT deduction offers a 25
Kaplow, supra note 14. See NATIONAL COMMISSION, supra note 11. 27 Kaplow, supra note 14, at 432-33. 28 See Brian Galle, A Republic of the Mind: Cognitive Biases, Fiscal Federalism, and Section 164 of the Tax Code, 82 IND. L.J. 673 (2007); see also Marika Cabral & Caroline Hoxby, The Hated Property Tax: Salience, Tax Rates, and Tax Revolts, (2010) (unpublished draft, Stanford University and National Bureau of Economic Research), http://economics.stanford.edu/files/Hoxby3_2.pdf. 26
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mechanism by which the federal government could serve to equalize state resources.29 Yet there are a number of problems with this proposal. First, it does not seem plausible politically; will richer American states really explicitly send revenues to poorer states?30 Second, the terms of equalization are far from clear - if what is to be equalized is fiscal capacity, then how will that be decided? For example, not all public goods cost the same in all places.31 If it costs more to build a school in a rural area, then will that area receive more than equal funds? And are only schools to be equalized, why not operas? Who decides? Finally (and relatedly), fiscal equalization threatens the hard budget constraints (i.e., no bailouts from the central government) that are generally seen as essential to a properly operating federal system.32 In other words, fiscal federalism relies on sub-national governments being responsible for their own destiny – if each sub-national government knew that, in the end, it would at least be equalized, then this encourages risky behavior.33 The SALT deduction can be given a macroeconomic function, and this is roughly the perspective that this Article adopts. Galle and Klick have argued that the SALT deduction (in conjunction with the Alternative Minimum Tax (AMT)) serves (clumsily) to automatically provide a subsidy to states and localities in the midst of an economic downturn because, as their incomes decline, fewer taxpayers pay the AMT and thus can take the SALT
29
Kirk J. Stark, Rich States, Poor States: Assessing the Design and Effect of a U.S. Fiscal Equalization Regime, 63 TAX L. REV. 957 (2010). 30 Stark is aware that this is not the American tradition of federalism and that the political challenges are daunting. Stark, supra note 29, at 957-58, 1007-08. 31 Geoffrey Brennan & Jonathan Pincus, Fiscal Equity in Federal Systems, 6 REV. L. & ECON. 347, 360 (2010). 32 Barry R. Weingast, Second Generation Fiscal Federalism: The Implications of Fiscal Incentives, 65 J. URB. ECON. 279, 285 (2009). 33 There is evidence of such moral hazard as to revenue sources. See, e.g., Thiess Buettner. Equalization Transfers and Dynamic Fiscal Adjustment: Results for German Municipalities and the U.S.-German Comparison, INSTITUTE FOR FEDERALISM AND INTERGOVERNMENTAL RELATIONS (Oct. 2007), available at www.ifigr.org/publication/ifir_working_papers/IFIR-WP-2007-07.pdf (finding that German sub-national governments, freed from suffering the full ill effect of their financial decisions because of equalization, opted to fund themselves with more volatile taxes).
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deduction.34 If the goal of the SALT deduction is to enhance macroeconomic stability in this way, then this structure is a Rube Goldberg mechanism for doing so. How, within the realm of achievable reforms, might the SALT deduction contribute more directly to greater state and local fiscal stability? Even on their own terms, all of these different analyses of the SALT deduction leave a great deal of room for additional theoretical analysis, but it is not as if these various approaches are consistent with one another even in outline. If, for instance, the SALT deduction is meant to equalize fiscal resources between states, then its current design, based on the situation of the individual taxpayer, makes little sense. If the deduction is meant to make the income tax a better measure of income on an individual level, then the deduction allowed for property taxes in particular – granted without regard to whether the property tax is a price voluntarily paid – is inappropriate. Yet there are still deeper issues to be considered. First, the federal financing subsidy undermines truly competitive federalism because the central government is putting its thumb on the scale in favor of certain activities – and specifically, borrowing.35 Furthermore, this subsidy allows sub-national governments to avoid internalizing the full cost of their borrowing because the borrowing is subsidized by the national government, and so this subsidy is particularly suspect.36 A second big issue implicit in the discussion of the SALT deduction is the question as to how tax competition in a federal system is to be organized. Advocates of tax competition sometimes speak of it in unqualified terms – i.e., the more competition the
34
Galle & Klick, supra note 13, at 211-17. For our purposes what is crucial is that for certain high income earners the AMT, I.R.C. § 55, takes away deductions that they could otherwise claim, like the SALT deduction. In an economic downturn, there are fewer such high income earners and so more taxpayers who take the SALT deduction, thereby putting more money into the national economy when and where it is most needed. 35 See, e.g., WALLACE E. OATES, FISCAL FEDERALISM 158 n.38 (1972); Giuseppe Eusepi & Richard E. Wagner, Polycentric Polity: Genuine vs. Spurious Federalism, 6 REV. L. & ECON., 329, 337 (2010). 36 See, e.g., Reiner Einchenberger & David Stadelmann, How Federalism Protects Future Generations from Today’s Public Debts, 6 REV. L. & ECON., 395, 398 (2010).
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better37 - and yet the matter cannot be so simple. The rickety structure of Dormant Commerce Clause jurisprudence is, for instance, designed (in part) to prevent sub-national jurisdictions from competing in tax exporting – tax exporting is generally seen as “bad” tax competition.38 Specifically, not all competition is created equal from the perspective of efficiency. Competition on tax rates (and public services) might be beneficial, but competition as to tax bases is probably not.39 And it is not chimerical to imagine a federal system with relatively stable tax bases, but competition as to rates and expenditures. This is arguably a rough approximation of the German federal system,40 and also of sales tax systems within states. The difference between competition as to rates and as to base leads to the question whether the SALT deduction should nudge states and localities towards competition as to a particular set of tax bases and, if so, which ones? In sum, the perplexities involving the SALT deduction only deepen when one considers other key sections of the Code and theories of fiscal federalism more broadly.41 To be sure, this Article cannot achieve a conclusive resolution of all these matters, but it takes a uniform approach to them that yields concrete policy proposals.
37
See, e.g., Eusepi & Wagner, supra note 35, at 339. See, e.g., Charles E. McLure Jr., The Nuttiness Of State And Local Taxes -- And The Nuttiness Of Responses Thereto, 25 STATE TAX NOTES 841 n.28 (Sept. 16, 2002). 39 Shaviro, supra note 14, at 975, 979-85. 40 Ronald L. Watts & Paul Hobson, Fiscal Federalism in Germany, 41-46 (2000), http://www.aucc.ca/_ pdf/english/programs/cepra/watts_hobson.pdf.; but see Lars P. Feld & Thushyanthan Baskaran, Federalism, Budget Deficits and Public Debt: On the Reform of Germany’s Fiscal Constitution, 6 REV. OF L. & ECON. 365, 374 (2010) (bemoaning fact that sub-national governments in Germany cannot control the rates of the primary taxes on which they rely). 41 No doubt the treatment here is not as broad as it might be, as it focuses on taxation issues and not issues, for example, of regulation. I hope that considering the almost $100 billion dollars at issue in these provisions (and the possibly bigger impact their redesign might have on the states) is broad enough to make a significant contribution. For a broader analysis, and one with which I largely agree (and draw from), see Super, supra note 14. Even this argument is not as broad as it might be, as a complete argument would also consider federal securities law relating to municipal finance and federal municipal bankruptcy law. 38
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B. Preliminary Objection The reforms this paper proposes would make the federal income tax a better tool in the context of fiscal federalism, but it would not make the federal income tax a better income tax. Specifically, the reforms will not help measure an individual taxpayer’s ability to pay. The most obvious response to this worry is to note that the notion of a pure income tax is very hard to cash out42 and, indeed, as I outlined above, theoretical issues plague the attempt to get the federal income tax treatment of state and local taxes theoretically correct. Furthermore, given the state of the Internal Revenue Code, it is awfully late in the day to be concerned about income tax purity. Still, one might object to making the Code more confounding for reasons having nothing to do with income tax theory, which is what I propose to do. I would like to address this objection straightaway. I respond, with Weisbach and Nussim, that pursuing income tax purity at the expense of other public finance and social goals is procrustean.43 There are certain policy objectives – perhaps administering certain kinds of credits – that are best administered through the income tax and not through a new federal bureaucracy. Achieving income tax purity at the expense of these other goals is like a homeowner using his leaf blower to blow all his leaves into a neighbor’s yard.44 Yes, the Internal Revenue Code could possibly be pristine, but only at the cost of creating huge and relatively inefficient federal bureaucracies doling out the Earned Income Tax Credit, education credits etc. So too here the Code will fail to
42
See, for example, the continuing debate as to what a tax expenditure is in practice. The statutory definition has not led to consensus. See, e.g., JCT, supra note 5, at 3-5 (summarizing issues and the JCT’s current approach, which is a return to an approach it had modified in 2008); David A. Weisbach & Jacob Nussim, The Integration of Tax and Spending Programs, 113 YALE L.J. 955, 97282 (2004) (summarizing and criticizing tax expenditure concept). 43 Weisbach & Nussim, supra note 42, at 957-83. 44 I am indebted to several students for the details of this analogy, though Weisbach and Nussim do themselves use the NIMBY analogy generally. See id. at 969.
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contribute to other traditional goals of tax policy in a federal system through a quixotic search for purity.45 The specific policy argument as to the federal role in local government finance is as follows. As the federal government is traditionally - and properly – charged with the primary task of (re)distribution within the national economy, so too the federal government is properly responsible for macroeconomic stabilization.46 In the case of distribution, the federal government could opt to fill its role through the creation of large federal bureaucracies or it can try to leverage the information it already gathers through the income tax, and this, put roughly, is what the Earned Income Tax Credit and the various education credits achieve.47 The federal income tax is similarly – and necessarily already interacting with state and local tax and borrowing decisions, and so the federal income tax code is in a position to nudge states and localities to more stable tax systems ex ante, obviating in part the need for federal interventions ex post.48 C. The Heart of the Matter: The Federal Interest in Ex Ante Stabilization Stabilization is the key reason for the federal interventions advocated here. State and local revenue systems have been showing greater and greater volatility, often greater than the underlying 45
The concern might not be with the Code as an abstract matter, but with complicating the Code pragmatically. There is a good argument to be made against making paying taxes harder for the average taxpayer. See, e.g., JCT, A RECONSIDERATION OF TAX EXPENDITURE ANALYSIS 37 (May 12, 2008). If this is the concern, then the reforms proposed here – especially just tweaking the above the line deductions – should pass muster. 46 See, e.g., OATES, supra note 35, at 30; RICHARD A. MUSGRAVE & PEGGY B. MUSGRAVE, PUBLIC FINANCE IN THEORY AND PRACTICE 606 (1973). If a single jurisdiction, say a city, engages in redistribution, then that city is, for example, likely to attract more beneficiaries in a mobile federation. Individuals are far less likely to make locational decisions based on the availability of redistribution at the national level. 47 Weisbach & Nussim, supra note 42, at 962-63, 1023. 48 This argument is analogous to the argument of Galle and Klick that the federal government should pursue its stabilization role automatically through the tax system and not through spending program once a crisis has begun. Galle & Klick, supra note 13, at 209.
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economy.49 In part this is because of the decline in use of the property tax and the increase in the use of other taxes.50 Both the sales and income taxes are more volatile than the property tax and both of these taxes are generally used by states in a manner that makes them more volatile still. The simple rule is: the narrower the base, the more volatile the tax, and the states apply income and sales taxes to a narrower than ideal base. A progressive income tax relies more on a small number of high-income taxpayers. A sales tax that only taxes transactions involving tangible property is more unstable than a sales tax that also includes services, especially because sales of tangible goods is a smaller, and shrinking, part of the economy. States have adopted income and sales taxes that are narrow in these ways.51 Thus states have not only moved to less stable tax bases in general (e.g., income v. property), but have made these taxes more unstable through their own design of these taxes. The federal government, as stabilizer of last resort, should not be subsidizing these taxes in general, much less as currently designed. We should also note the role of state and local debt. The use of debt at the state and local level has increased over the last decades.52 Debt is often appropriate, especially for spreading the cost of capital projects across generations, but several aspects of this increase are particularly worrying. To begin with, there is good reason to wonder whether it is appropriate for the central government to subsidize sub-national borrowing at all. Prima facie this subsidy undermines the hard budget constrains so important to fiscal federalism. If the subsidy is 49
See REPORT OF THE COMMISSION ON THE 21ST ECONOMY, supra note 3, at 27; see also Stark, supra note 13, at 416-19; HOLCOMBE & SOBEL supra note 1. 50 For the details of the decline of the property tax, see Part III.F. infra. 51 Cf. Stark supra note 13, at 421-23 (summarizing research and arguments and coming to similar conclusion, though noting that some of the evidence is equivocal). 52 See, e.g., John Joseph Wallis and Barry R. Weingast, Dysfunctional or Optimal Institutions?: State Debt Limitations, the Structure of State and Local Governments, and the Finance of American Infrastructure, at tbl. 2 (data through 2002), http://lawweb.usc.edu/centers/cslp/documents/WallisWeingast.DysfunctionalInstitutions.13_DI_try.06.0202_000.pdf; STEVEN MAGUIRE, STATE AND LOCAL GOVERNMENT DEBT: AN ANALYSIS, CONGRESSIONAL RESEARCH SERVICE, at tbl. A-2 (Mar. 31, 2011) (data from 2002 to 2009).
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consistent with the theory of fiscal federalism, then it is through creating (or mitigating) positive (or negative) inter-jurisdictional externalities.53 Yet the subsidy is not limited to the financing of such regional projects. Furthermore, it has long been understood that, as designed, the federal financing subsidy is “leaky” because it provides more subsidy to higher income taxpayers than local governments receive.54 Then there are specific worries. Though the amount of state and local debt has not increased in gross terms in the last decade, the amount of debt owed by states versus localities has continued to increase.55 This suggests that, as in other areas, states have continued to expand their role relative to localities, even as statelevel financing has become more unstable. This has had two implications. First, state budgets have become more constrained because greater parts of the budget are dedicated to debt service.56 Second, states are using general tax dollars for projects that can finance themselves. 57 Finally, states have allowed their localities to use speculative land-secured financing techniques in ways that contributed to the over-heating of the housing market and, amidst the crash, these financings have further undermined state and local tax bases.58 Again, it is the federal government that has historically stepped in to provide macroeconomic stimulus in times of economic
53
Gillette, supra note 14, at 1040-49; for the general principle that the central government should attend to inter-jurisdictional spillovers see MUSGRAVE & MUSGRAVE supra note 46, at 609-10; GRUBER supra note 67, at 273. 54 See, e.g., JCT, PRESENT LAW AND BACKGROUND RELATING TO STATE AND LOCAL GOVERNMENT BONDS 7-8 (2006). 55 Robert W. Wassmer & Ronald C. Fisher, State and Local Debt, 1992-2008, 61 STATE TAX NOTES 427, 428 (Aug. 15, 2011). Though I believe the evidence for the over-use and misuse of the federal financing subsidy is substantial, I plan to do further work on trying to disentangle the exact magnitude of the problem. 56 See, e.g., CALIFORNIA LEGISLATIVE ANALYSTS OFFICE, CALFACTS 65 (2011) (warning that the debt service burden on California’s General Fund has recently increased to 6% and could increase to 9%). 57 See Darien Shanske, Going Forward by Going Backward to Benefit Taxes, 3 CALIF. J. POL.& POL’Y 1, 2-3 (2011). 58 See generally Darien Shanske, Above All Else Stop Digging: Local Government Law as a (partial) Cause (and Solution) to the Current Financial Crisis, 43 MICH. J. L. REFORM 663 (2010).
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crisis,59 a task made more difficult by the procyclical movements of state and local revenues and the misuse of state and local debt. This role for the federal government has long been seen as theoretically appropriate; for instance, it is only the federal government that can provide a large fiscal stimulus knowing that most of the stimulus will not escape the jurisdiction.60 And, our law follows theory here to a considerable degree given that in general it is the federal government, and not state or localities, that can borrow in times of crisis.61 Yet given its current fiscal situation, the federal government is likely to be less, not more, able to step in and counteract state procyclical spending cuts during downturns.62 However, even if the federal government were to eschew this stabilizing role, it is still bound to state fiscal fortunes by numerous joint federal-state programs, such as Medicaid. Though the specific design of many of these programs may be questionable, the theoretical idea that there is a joint state-federal interest in the health care of the indigent seems unassailable to this observer. It is canonical to theories of fiscal federalism that it is the central government that ought to look after the weakest in society. It could be objected that all these federal interventions obstruct the operation of beneficial competition between states and localities. Yet, as noted above, sophisticated advocates of fiscal federalism do not advocate just any kind of competition. Competition between states predicated, for instance, on tax bases versus rates, is probably not, on balance, beneficial. The proposals herein would channel tax competition to the kind of competition recommended by our best theories of tax assignment.
59
Cf. Inman supra note 10, at 68-69 (noting that the federal government has an interest in encouraging proper use of state and local debt (which is often not used properly), but not discussing the various federal financing subsidies). 60 See, e.g., MUSGRAVE & MUSGRAVE, supra note 46, at 607. 61 See, e.g., Glenn Follette & Byron Lutz, Fiscal Policy in the United States: Automatic Stabilizers, Discretionary Fiscal Policy Actions and the Economy, at 16, 19 (Finance and Economics Discussion Series Division of Research and Statistics and Monetary Affairs Federal Reserve Board, Working Paper No. 2010-43, Jun. 28, 2010). 62 See Richard F. Dye, What Will the Future Property Tax Look Like? in THE PROPERTY TAX AND LOCAL AUTONOMY 229-30 (Michael E. Bell et al. eds., 2010).
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There are also limits to the analogy between public and private markets that undergirds the competition argument.63 States cannot go bankrupt and localities rarely do, and so the market for jurisdictions is not the same as the private market where painful bankruptcy and ultimately liquidation are much more real options. This disanalogy has to do with the current state of the law,64 and the law is unlikely to change as a matter of fact, but the law as it is is not just an accident, but is based on the nature of public versus private entities.65 We do not want all the public schools in a particular district to be liquidated nor all police service in a particular town to be discontinued. This has to do with the public nature of the goods these entities generally provide (e.g., neighboring communities will suffer if a bankrupt town is engulfed by crime or flames), but also with the political nature of these entities and the value we attribute to them even amidst financial distress. Should the political community I have formed with my neighbors over decades be dissolved because the current city manager made poor business decisions? And thus it is reasonable that the law governing municipal bankruptcy is not the 63
The classic modern statement of a role for local governments as creating the opportunity for democratic participation is Gerald Frug, The City as a Legal Concept, 93 HARV. L .REV. 1057 (1980). Even theorists skeptical of the extent of Frug’s arguments concede the practical normative import of his arguments. See, e.g., Richard Briffault, Our Localism: Part II—Localism And Legal Theory, 90 COLUM. L. REV. 346, 416 (1990) (“The idea of local governments as governments—as centers of collective decision making rather than as firms that supply goods to the municipal marketplace—is certainly the underpinning of the legal authority of local governments.”). 64 On the current, unsettled state of the law on public employee contracts, see, for example, James E. Spiotto, Chapter 9: The Last Resort for Financially Distressed Municipalities in THE HANDBOOK OF MUNICIPAL BONDS 145, 164-65 (Sylvan G. Feldstein & Frank J. Fabrozzi, eds., 2008); see also, for example, In re City of Vallejo, 432 B.R. 262 (E.D. Cal. 2010) (affirming bankruptcy court’s rejection of public employee contracts only after, among other things, a balancing of the equities). As for other limits, see, for instance, 11 U.SC. § 109(c)(4) (locality must choose bankruptcy); 11 U.S.C. § 904 (limited powers of federal judge); Kevin A. Kordana, Tax Increases in Municipal Bankruptcies, 83 VA. L. REV. 1035, 1059-67 (1997) (bankruptcy judge probably cannot require tax increases and should not). 65 And so I think commentators have been too quick to advocate an expansion of the bankruptcy option to states and/or generally to advocate less aid to states and localities ex post. See, e.g., David A. Skeel Jr., Give States a Way to Go Bankrupt: It’s the Best Option for Avoiding a Massive Federal Bailout, 3 CAL. J. POL. & POL’Y 19 (2011); Inman supra note 10, at 69-70, 78.
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same as the law governing the bankruptcy of private entities – and it will not become the same. Because sub-national entities are not going to be subject to the full consequences of poor financial decision-making ex post, it is particularly important that the federal government nudge these other entities to better policies ex ante. To be sure, at some point such nudging will go too far and undermine the rationale for fiscal federalism, but I do not think the reforms proposed here, reforms to already existing programs, come close to rising to that level. It is also the case, of course, that the federal government cannot necessarily afford every possible clever nudge. Hence we must remember that the reforms under consideration could – and should – result in net savings to the federal government. D. Connection to the Benefit Principle From the federal perspective of encouraging stabilization, the federal government should take the position that the benefit principle of taxation should be used to the extent possible.66 The benefit principle states: the government should levy taxes on citizens in proportion to the benefits that citizens demand from the government.67 The benefit principle enhances stability both by limiting spending (i.e., voters only get what they want) and making it easier to raise revenue (i.e., voters know where their money is going). Given that governments cannot apply the benefit principle perfectly,68 the practical manifestation of the benefit principle in taxation is through imposing levies on specific taxpayers for specific goods or services to the extent possible.69 Applied to the theory of 66
See e.g., McLure supra note 38; see also generally David G. Duff, Benefit Taxes and User Fees in Theory and Practice, 54 U. TORONTO L.J. 391 (2004). I have made this argument in the California context in two related pieces, see Shanske, supra note 57; Darien Shanske, Putting the California Constitution (Back) to Work: A Blueprint for Clearing Legal Roadblocks to Proper Infrastructure Finance, 54 STATE TAX NOTES 567 (2009). 67 MUSGRAVE & MUSGRAVE, supra note 46, at 195; JONATHAN GRUBER, PUBLIC FINANCE AND PUBLIC POLICY 231 (3d. 2010). 68 This is the so-called preference revelation problem. See, e.g., GRUBER, supra note 67 at 231-32. 69 See, e.g., MUSGRAVE & MUSGRAVE supra note 46, at 196; Duff, supra note 66, at 393-94.
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tax assignment in a federal system, the benefit principle indicates that taxes should be assigned to the lowest level of government consistent with the provision of the goods or services that the taxes are to be spent on.70 Thus, taxes to support schools are generally assigned to the local level so that taxpayers can observe the connection between their taxes and their schools and can then vote for the level of provision that they want. For national defense, such assignment is not possible, and it is properly the role of the central government. In some circumstances, the property tax acts as a benefit tax71 and in any properly designed special assessment the assessment even more approximates a benefit tax. Hence, I will argue that both property taxes and special assessments should be favored by the federal income tax. State sales taxes and income taxes have the least benefit-type characteristics, which is why they are typically not assigned to local governments to raise revenue and should not be encouraged by the national government.72 Reforming the federal financing subsidy is also consistent with the benefit principle because my proposed reforms would require a tighter connection between the (national) costs of the subsidy and (national) benefits. Specifically, the proposal is that the federal financing subsidy should only be used for projects of regional significance. If the subsidy is not being used in connection with inter-jurisdictional externalities, then the federal government is either subsidizing projects that do not need help or encouraging the pursuit of infra-marginal projects. If the latter, then the federal government is encouraging borrowing that undermines state and local stability because, by definition, the money spent on this borrowing would be better spent elsewhere (or not at all). 70
MUSGRAVE & MUSGRAVE, supra note 46, at 596-97; GRUBER supra note 67, at 273-74; OATES, supra note 35, at 35; Charles E. McClure Jr., The Tax Assignment Problem: Ruminations on How Theory and Practice Depend on History, 54 NAT’L TAX J. 339, 343-44, 352 (2001). Note that traditional tax assignment theory also assigns the most stable taxes to the lowest levels of government precisely because the lowest level of governments are not in a position to undertake macro-economic stabilization. Richard A. Musgrave, Who Should Tax, Where, and What?, in TAX ASSIGNMENT IN FEDERAL COUNTRIES 2, 12-13 (Charles McLure ed. 1983). 71 For instance, to the considerable extent that the local property tax is still used for school finance. See generally WILLIAM FISCHEL, THE HOMEVOTER HYPOTHESIS 39-71, 99-100. 72 See Musgrave supra note 70, at 13.
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Given the connection between the benefit principle and stabilization, one might assume that the benefit principle provides a big part of the analytical framework for the federal government’s stabilization function. Indeed this is so, and some role for the benefit principle is not controversial73 and brings together the political right74 and the left. Thus even commentators perceived as more concerned with the ability to pay principle, such as Murphy and Nagel, see the place of benefit taxes, though they are careful to explain that benefit taxes are appropriate only in the context of an already generally just distribution of resources.75 We might give this a federalism gloss by saying that benefit taxes at the local level are justified if the central government is making sure there is a generally just distribution of resources. Nevertheless, the benefit principle does not exhaust the federal imperative to stabilize for a variety of reasons. First, not all benefit-type levies need the same level of federal support. User fees, such as for waste pickup or water, hew even more directly to the benefit principle because they are more of a direct fee for a service and thus, when applied properly, are most efficient of all at giving taxpayers what they want at the price they want.76 Yet I do not think that the SALT deduction should allow a deduction for user fees, but do think that it should allow for a deduction for property taxes and special assessments (and, ideally, exclusively so). The reason for this choice is that there does not appear to be a national tax assignment problem affecting the utilization of user fees77 and 73
CALIFORNIA COMMISSION ON THE 21ST CENTURY ECONOMY, supra note 3, at 32-33 (recent reformers from different political perspectives arguing that California should impose more taxes according to a benefit principle). 74 See, e.g., Richard A. Epstein, The Ubiquity of the Benefit Principle, 67 S. CAL. L. REV. 1369 (1994) (support of benefit principle from generally libertarian perspective). 75 LIAM MURPHY & THOMAS NAGEL, THE MYTH OF OWNERSHIP, 16-19, 85 (2002). 76 R.M. Bird & T. Tsiopoulos. User Charges for Public Services: Potentials and Problems, 45 CAN. TAX J. 25 (2007). 77 See generally, Ross E. Coe, Federalism’s Vanguard: Local Government User Fees, 61 STATE TAX NOTES 561 (Aug. 29, 2011) (chronicling rise of fees and concomitant decline of property taxes since the 1970s). Coe also argues that an expansion in the use of fees should be contemplated as a stable source for local government finances, having given up, apparently, on property taxes. This is certainly a reasonable position, one I essentially agree with, but I do not think that
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therefore the federal government should not change the rule that such fees are not deductible because they are for private consumption. This is not to say that there is no federal interest in proper utilization of user fees. To the contrary, there is and that interest can be vindicated through the federal financing subsidy; there is no reason to subsidize user fees twice. The use of property taxes and assessments has declined over the last hundred years, and these are what the federal government should encourage. The main reason that we cannot rely wholly on the benefit principle is that its connection with the property tax is equivocal, and so it would be perilous to say that the federal government should advocate for the property tax because it is a benefit tax. Even if not a benefit tax, the property tax has desirable characteristics for other reasons: for instance, it is a relatively stable tax because of how it is collected and it is efficient because of its uniformity. We will address these reasons in depth in Part IV infra. For now, the primary point is that the stabilization justification for the property tax is related to, but ultimately broader, than the benefit principle. Let us consider a final related objection. After all, allowing for either a deduction or an exemption reduces the cost of benefit taxation at the local level; why should the federal government essentially give a discount on (certain) local services?78 The familiar answer from within the benefit principle is that the central government is properly concerned with inter-jurisdictional externalities, positive or negative. This answer is most satisfying as applied as to the tax exemption for state and local government borrowing, which exemption, ideally, would only be available to subsidize projects that generate positive externalities/or mitigate negative ones relative to the financing jurisdiction. fees can possibly expand to replace the entire property tax nor that the federal government has an interest in such a shift. 78 Kogan in a recent draft paper finds evidence that federal deductibility encourages the imposition of local taxes, but assumes that this “tax contagion” is inefficient because it lowers the tax price that voters must pay for local tax increases. Yet Kogan does not entertain the argument – at the center of this paper – that, from the perspective of the federal government, the tax price for local property taxes is sub-optimally high. See Vladimir Kogan, Vertical Spillovers in Local Politics: How Federal Tax Laws Shape Voter Support For Local Tax Increases (Dec. 22, 2009) (Unpublished draft), http://polisci2.ucsd.edu/vkogan/research/spillovers.pdf.
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But what of subsidizing the property tax through deductibility? I am not making any proposal that only property taxes that create positive inter-jurisdictional externalities be deductible. Yet my argument can and should be understood in terms of interjurisdictional externalities. The instability of sub-national tax systems is undermining the national economy, so too the transaction costs of multiple inconsistent sub-national tax bases and the dramatically inequitable spending cuts that fiscal volatility results in. Currently, the relatively uniform and stable property tax base is being underused and the federal SALT subsidy diffused aimlessly, but at great expense. What I am arguing is that the federal government focus its subsidy on the suboptimal use of the property tax in order to better play its stabilization role. The decline of the property tax is a national tax assignment externality. III. Background: A Short, Broad, and Tendentious History of the Federal-State Tax Interaction A key claim of this Article is that the federal government is in a position to do more with less by tweaking the interaction between the federal and state tax systems. It could be objected that this is prima facie implausible, but I believe a brief review of the history of the key provisions under discussion demonstrates that they represent a series of ad hoc decisions and can easily be unified and improved.79 A. SALT Itself: I.R.C. § 164(a) The deduction for state and local taxes was already in the original version of the Internal Revenue Code.80 This deduction was 79
Suzanne Mettler recently identified the SALT deduction as a component of the “submerged state”; this provision was placed in the Code with little fanfare and has since ballooned in importance. SUZANNE METTLER, THE SUBMERGED STATE 12, 16 (2011). As will become clear, I think a similar story can be told about the Section 103 exclusion. Note that my concern (in contrast to that of Mettler) is not with revealing these provisions (not that I am opposed to that); rather, my aim is to rationalize these submerged provisions so that they can at least do some good. 80 Revenue Act of 1913, ch. 16, 38 Stat. 114 (1913) (codified as amended at 26 U.S.C. §164). Indeed, a similar deduction was in the original code instituted during the Civil War, an issue that came up repeatedly during the debate as to whether to repeal the deduction as part of tax reform in 1985. See, e.g., Federal
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not a product of extensive discussion, though over the decades there have been some discussions of Section 164, most notably in the mid1980s in the discussion preceding the Tax Reform Act of 1986. The Reagan Administration initially proposed repealing the deduction altogether, a proposal that attracted an enormous amount of criticism.81 The final reform eliminated the deduction for sales taxes; this deduction too has crept back into the Code. B. Exception for Special Assessments: I.R.C. § 164(c)(1) Section 164(c)(1) denies the SALT deduction for “taxes assessed against local benefits of a kind tending to increase the value of the property assessed,” though this section does allow the deduction for interest expenses. One assumes, and the main report I know of confirms,82 that this provision is not much followed. That is, taxpayers just deduct all the items on their property tax bill, whether or not they are non-deductible assessments. The predecessor to current section 164(c)(1) was in the original income tax code of 191383; there has been little discussion of it then or since. In essence this section means that so far as a state or local charge is tightly tied to a benefit, then it is no more deductible than any other expenditure for private consumption.84 Though untheorized (so far as I know), Section 164(c)(1) is consistent with the view that the SALT deduction only aims to provide deductions for state and local taxes that do not serve as prices for essentially private consumption.
Income Tax Deduction for State and Local Taxes, Hearing Before the Subcomm. on Intergovernmental Relations 99th Cong., 3, 26 (1985). 81 See, e.g., JEFFREY H BIRNBAUM & ALAN S. MURRAY, SHOWDOWN AT GUCCI GULCH 113-16 (1987) (detailing part of the battle). 82 U.S. GOVERNMENT ACCOUNTABILITY OFFICE, REAL ESTATE TAX DEDUCTION: TAXPAYERS FACE CHALLENGES IN DETERMINING WHAT QUALIFIES; BETTER INFORMATION COULD IMPROVE COMPLIANCE (2009), available at http://www.gao.gov/new.items/d09521.pdf. 83 Revenue Act of 1913, ch. 16, 38 Stat. 114 (1913). 84 Early commentators like the Blakeys, glossed this provision as denying the deduction for “ordinary special assessments.” ROY G. BLAKEY & GLADYS C. BLAKEY, THE FEDERAL INCOME TAX 96 (1940).
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C. Exclusion for the Interest on State and Local Bonds: I.R.C. § 103 Section 103, the exclusion from taxation for interest on state and local bonds, also dates to the original Code. It also received little discussion, though this is understandable since whether the federal government could legally tax this interest was not made clear until 1988.85 In addition, it was seen as politically inadvisable to tax interest on state bonds. This seemed to have been an issue in connection with the passage of the Sixteenth Amendment – proponents of the income tax insisted that the new tax would not tax “the instrumentalities of a State or a subdivision thereof.”86 In 2011, there is no question that the federal government can repeal Section 103 or attach other conditions to the use of the tax exemption.87 As noted briefly above, there are numerous policy objections to Section 103.88 For instance, as an exclusion from income tax, the benefit derived from Section 103 is worth more the higher one’s marginal rate (as with the SALT deduction). Also, a government entity only gets the benefit of the exclusion to the extent it borrows, which is a perverse incentive if we are looking to enhance stability. There is also little reason for the federal government to subsidize just any state or local project; the federal government should only subsidize projects that generate positive externalities/or mitigate negative ones relative to the financing jurisdiction.89 None of these (or other) concerns had much effect on Section 103, until recently.90 85
50 Congressional Record 508 (Apr. 26, 1913) (Statement of Mr. Hull). For the central role of Congressman Hull in designing and advocating for the income tax, see BLAKEY & BLAKEY, supra note 84, at 75-76. 86 50 Congressional Record 508 (Apr. 26, 1913) (statements of Mr. Hull and Bartlett). 87 See South Carolina v. Baker, 485 U.S. 505 (1988). For proposals to reform the exemption see note 12 supra; see also H.R. 567, 112th Cong. (2011) (Public Employee Pension Transparency Act would place additional disclosure requirements on issuers of tax-exempt bonds). 88 See generally 151 Kevin M. Yamamoto, A Proposal For the Elimination of the Exclusion For State Bond Interest, 50 FLA .L. REV. 145 (1998). 89 Gillette, supra note 14, at 1042. 90 There were some early engagements with the tax exemption; FDR, for example, tried and failed, to eliminate the tax exemption in 1938. See DENNIS ZIMMERMAN, THE PRIVATE USE OF TAX-EXEMPT BONDS 43-44 (1990); Yamamoto supra note 88, at 167-70.
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D. Above the Line Deduction for Real Property Taxes: I.R.C. § 63(c)(1)(C) In 2008, Congress approved a two-year above the line deduction specifically for property tax payments. The provision allowed a deduction for the lesser of “the amount allowable as a deduction under this chapter for State and local taxes described in section 164(a)(1) [the tax on real property], or $500 ($1,000 in the case of a joint return).” An above-the-line deduction is a deduction that all individual taxpayers can take, regardless of their other deductions. Formally, these are the deductions listed in I.R.C. § 62. Theoretically, these are the deductions that are allowed because they (usually) reflect the cost of earning income and so should be included in the measurement of income in the first instance.91 Other deductions, the so-called itemized deductions indicated in I.R.C. § 63(d), are only, pragmatically, available to taxpayers that do not take the standard deduction of I.R.C. § 63(c). About two-thirds of taxpayers take the standard deduction.92 To use an example. Assume that the standard deduction is $5,000 and that taxpayer Y has paid $4,000 in property taxes that would be deductible under the SALT deduction. Yet the SALT deduction is an itemized deduction and so Y should choose the standard deduction and is not helped by the SALT deduction; she deducts $5,000. One can readily see why, in general, only wealthier taxpayers, i.e. those taxpayers with higher state and local tax liability and other possible itemized deductions (like for charitable giving), actually take advantage of the SALT deduction.93 Therefore, by allowing a certain portion of Y’s property tax liability to be deducted above the line, say $500 worth, Congress has allowed Y to enjoy the benefit of the SALT deduction and the standard deduction, for a total deduction of $5,500 rather than $5,000. 91
PAUL R. MCDANIEL ET AL., FEDERAL INCOME TAXATION 695 (6th ed. 2008). Statistics of Income Division, I.R.S., All Returns: Adjusted Gross Income, Exemptions, Deductions, and Tax Items, classified by Size of Adjusted Gross Income and by Marital Status (Pub. 1304, Tax Year 2008), at tbl 1.2. 93 Wealthier taxpayers also benefit more because the deduction is more valuable the higher one’s marginal tax rate. See Stark, supra note 18, at 426. 92
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The specific reasoning for this temporary reform was sparse; for instance, here is the House Committee on Ways and Means: The Committee believes an additional standard deduction for real property taxes is appropriate in order to help lessen the impact of rising State and local property tax bills on those individual taxpayers with insufficient total itemized deductions to elect not to take the standard deduction.94 So far as this observer knows, there was no increase in property tax bills at this time – unless the Committee meant that, because of falling house prices, property taxes were increasing as a percentage of a house’s then-current market price because the assessments of local assessors was lagging the market. If this is so, then this change might have had some small impact on influencing taxpayers to stay in their homes, especially if they were not itemizers. E. Build America Bonds: I.R.C. § 54AA As a response to the Great Recession, Congress made Build America Bonds (BABs) available to state and local governments in addition to the exclusion available under Section 103.95 BABs are a kind of tax credit bond. The most popular form of BAB worked (roughly) like this:96 A local government or state issues bonds for a project on the taxable market. The federal government then writes the governmental issuer a check for a certain percentage of the interest owed, 35% under the original program. Because the subsidy is paid directly to government issuers, this subsidy is more efficient than the traditional Section 103 subsidy. Furthermore, because BABs were taxable they were expected to allow state and local governments to reach more customers, even in an unsettled market. The original BAB program, which expired at the end of 2010, was generally deemed to be a success. As the Obama administration explained:
94
H.R. Rep. No. 110-606, at 41-41 (2008). I.R.C. § 54AA. 96 I.R.C. § 54AA(g). 95
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From April 2009 through December 2010, more than $181 billion in Build America Bonds were issued in over 2,275 transactions . . . During 2009-2010, Build America Bonds gained a market share of over 25 percent of the total dollar supply of State and local governmental debt.97 Consistent with this success, the administration has proposed reviving and expanding the BAB program. In particular, the administration would allow BABs to be used for a wider variety of projects.98 The administration would lower the reimbursement rate from 35% to 28%, reasoning that “[t]he 35-percent Federal subsidy rate for the original Build America Bond program represented a deeper Federal borrowing subsidy for temporary stimulus [and that currently] it is appropriate to develop a revenue neutral Federal subsidy rate relative to the Federal tax expenditure on tax-exempt
97
GENERAL EXPLANATIONS OF THE ADMINISTRATION’S FISCAL YEAR 2012 REVENUE PROPOSALS 20-21. There is also evidence that, indeed, the BABs program was popular for a reason, namely that it lowered borrowing costs relative to traditional Section 103 borrowings. Gao Liu & Dwight Denison, Indirect and direct subsidies for cost of government capital: Comparing tax-exempt bonds and Build America Bonds 18 (Jan. 19, 2011), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1764703 (“[I]t is found that BABs have a lower after-subsidy interest cost of 54 basis points lower than that of tax exempt bonds. After controlling for the difference of other factors by setting all other variables at their mean values, the estimated saving is even larger. Issuers can save 72 basis points . . . by issuing BABs instead of tax exempt bonds.”). But see Mark D. Robbins and Bill Simonsen, Build America Bonds, 30 MUN. FIN. J. 53, 67-68, 74 (2010) (BABs were more expensive than comparable taxable bonds). These two papers could be consistent with one another: BABs might have been a better deal for municipal issuers because they received a greater federal subsidy, but the federal government did not get a better deal because the federal subsidy is scaled to interest rates and the interest rates that municipal issuers received were higher than anticipated. To use numbers, let us imagine that the ordinary tax exempt borrowing rate was 8% and the ordinary taxable rate was 10%. The federal government might have hoped that a municipality would borrow at 10% and that, accordingly, its subsidy rate would be 3.5%. However, assume that the municipality in fact borrows at 11% and the federal government must pay 3.85%. Yet, even at 11%, the real borrowing rate for the municipality is 7.15%, still better than the regular Section 103 rate. 98 See GENERAL EXPLANATIONS OF THE ADMINISTRATION’S FISCAL YEAR 2012 REVENUE PROPOSALS, supra note 97, at 21.
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bonds.”99 Note that in expanding this program the Administration has not proposed any additional regulation of the tax-exempt market (indeed the Administration’s proposal would loosen the limits on the use of BABs and traditional Section 103 financings). F. A Tangled History The initial federal income tax only applied to a small number of high income tax payers.100 Thus the first big shift to consider is that the SALT deduction is now a feature of a “mass tax.”101 Additionally, because of the advent of the standard deduction, the Alternative Minimum Tax (AMT) and Section 68,102 the SALT deduction is in effect claimed only by a hard to justify slice of taxpayers defined by their income, property ownership and geographical location (i.e., their local tax rates). This slice is hard to justify because not only is it relatively higher income taxpayers that get to deduct at all, but not all such taxpayers because of the 99
See GENERAL EXPLANATIONS OF THE ADMINISTRATION’S FISCAL YEAR 2012 REVENUE PROPOSALS, supra note 97, at 21. There is academic research supporting this rate. See Liu & Denison, supra note 97 at 18-20 (finding the neutral rate to be 25%). If all purchasers of BABs were taxable at this rate (25%), then the BAB program would be a wash for the federal government because it would recoup its subsidy through taxing the investors. However, BABs, by expanding the pool of possible investors, have likely expanded the pool to individuals with a marginal rate lower than the reimbursement rate and to entities that do not pay income tax at all. Of course, all this market expansion should lower interest rates on BABs relative to taxable bonds, though this does not seem to have happened yet. Robbins & Simonsen, supra note 97, at 66-68 (evidence on expanding the pool of investors in BABs relative to Section 103 bonds, but also evidence that BABs issued at higher rate than comparable taxable bonds). 100 T.A. Garrett & R. M. Rhine. On the Size and Growth of Government, 88 FEDERAL RESERVE BANK OF ST. LOUIS REV. 13, 27 (2006). 101 W. Elliot Brownlee, Tax regimes, national crisis and state-building, in FUNDING THE MODERN AMERICAN STATE 93 (W. Elliot Brownlee ed., 1996); Dennis Ventry, The Accidental Deduction: A History and Critique of the Tax Subsidy for Mortgage Interest, 72 LAW & CONTEMP. PROBS 233 (2010) (similar history about the rise of the mortgage interest deduction). 102 26 U.S.C. § 68 contains a complicated phaseout of itemized deductions, including the SALT deduction. Section 68 was itself subject to phaseout as part of the 2001 Bush tax cuts, but this phaseout is itself set to end in 2012. Pub. L. No.111-312, § 101(a). For a helpful summary, see MCDANIEL ET AL., supra note 91, at 763-64.
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operation of the AMT and Section 68 (when in effect), and only to the extent that a state has high enough taxes of the correct sort (e.g., income versus sales).103 At the time of the SALT deduction’s inception, the primary state and local tax was the property tax. As the applicability of the SALT deduction has broadened in terms of taxpayers, so too has the kind of taxes to which it applied as the states and localities diversified their tax bases. Taxpayers have generally been able to deduct state and local income taxes and for large periods have been able to deduct sales taxes as well. Yet it should also be observed that, as marginal tax rates have fallen since the 1980s, so has the value of this deduction,104 and this indicates that this is a smaller benefit that is now dispersed more broadly, though arbitrarily, and not, in effect, to two-thirds of taxpayers. Yet the key part of the story that I would like to emphasize is the decline of the property tax. This is not controversial and can be measured in various ways.105 For instance, property taxes represented 73% of all local government revenue in 1902, but 40% in 1992.106 Even more strikingly, property taxes were 68% of combined state and local revenues in 1902, but 18% in 1992.107 In other words, the decline in the role of the property tax has been extremely dramatic when one considers revenues at the state and local level, but it has also declined significantly looking at the local level alone. Thus, between 1977 and 1997, the percentage of the property tax as a percentage of own-source municipal revenues 103
Cf. Kim Reuben, The Impact of Repealing State and Local Tax Deductibility, 37 STATE TAX NOTES 497 (2005). 104 Jennifer Gravelle & Sally Wallace, Overview of Trends in EROSION OF THE PROPERTY TAX BASE, 43 (Augustine et al. eds., 2009) 105 Eric M. Zolt, Inequality, Collective Action, And Taxing And Spending Patterns Of State And Local Governments, 62 TAX L. REV. 445, 497 (2009); HOLCOMBE & SOBEL, supra note 1, at 51; Cabral & Hoxby, supra note 28, at 23-24. 106 John Joseph Wallis, A History of the Property Tax in AMERICA IN PROPERTY TAXATION AND LOCAL GOVERNMENT FINANCES 123 (Wallace E. Oates ed., 2001).. 107 Id. An oft-cited rule of thumb is that the property tax should account for twenty to thirty percent of state-local revenue. See, e.g., RONALD JOHN HY & WILLIAM L. WAUGH, JR., STATE AND LOCAL TAX POLICIES: A COMPARATIVE HANDBOOK 49 (1995) (following Robert Kleine and John Shannon, Characteristics of a Balanced and Moderate State-Local Revenue System, (1985)). Though I agree that the property tax is under-utilized, I explain in Part III.G. infra why I am not relying on a particular percentage as a one-size fits all model.
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declined in forty-nine of fifty states, from a total of 42.7% to 28.8%.108 The decline also occurred when one views the property tax relative to individual income, as the property tax represented 7% of personal income in 1930, but less than 3% in 2007.109 Less well known is that the use of assessment-type financing – the presumed concern of Section 164(c)(1) - was also much more prevalent in 1913 (and long before).110 This means, at least as to the small number of taxpayers initially paying the federal income tax, the assessments that would have fallen under 164(c)(1) were significant.111 These assessments would not have been deductible, but the general property tax would have been. As with the general property tax, the use of assessment financing in the US also declined
108
Dale Krane et al., Devolution, Fiscal Federalism, and the Changing Patterns of Municipal Revenues: The Mismatch between Theory and Reality, 14 J. PUB. ADMIN. RES. & THEORY 513, 523 (2004). 109 See Gravelle & Wallace, supra note 104 at 18-19. 110 Stephen Diamond, The Death and Transfiguration of Benefit Taxation: Special Assessments in Nineteenth-Century America, 22 J. LEGAL STUD. 201, 202 (1983). (“In the United States, the special assessment developed simultaneously with the general property tax as one of the twin financial pillars of state and local government.”). See also VICTOR ROSEWATER, SPECIAL ASSESSMENTS: A STUDY IN MUNICIPAL FINANCE 78-79 (1893) (reporting that assessments could account for as much as 50% of receipts for many cities in 1890, including San Francisco and Chicago). 111 One of the rare (and early) cases about this provision is Belfast Investment Co. v. Commissioner, 17 B.T.A. 213 (1929). The holding of this case is that the federal courts will not second-guess state and local law as to what is or is not a valid assessment. Id. at 231. From a historical perspective, more interesting is the extensive list of assessments that the taxpayer attempted to deduct ($6,854.11 in 1918 alone), id. at 219, and this description of local public finance in Kansas City at the time: General public improvements in Kansas City, Mo., are not paid for in full out of general taxes. The levy for taxes for city purposes is limited by the state law and it is impossible for the city to levy a general tax sufficient to pay for the general public improvements that are carried on in the city. In order to provide sufficient money to make various improvements the city resorts to creating special benefit districts. The property within such districts is then taxed in proportion to the benefit which the city determines the property derives from the improvement. The benefit district is passed upon by the common council. There is then a public hearing. Id. at 220.
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in the Twentieth Century, but the major turn was earlier, during the Great Depression.112 The initial structure of Section 164 thus seemed to accord well (if accidentally) with traditional income tax principles. Taxpayers could not deduct assessments that seemed most likely to resemble private consumption, and these were often a significant amount of money. However, the general property tax, somewhat less likely to be connected to a specific benefit, could be deducted. Remember that the income tax only applied to the wealthiest taxpayers and it seems plausible to surmise that these taxpayers were the ones least likely to benefit from their higher property taxes in proportion to their cost, especially in an era when benefit assessments were much more common. Given that currently the volume of local assessments has declined considerably and the SALT deduction is available more broadly, this distinction is far less apt. At the time of the initial granting of the Section 103 tax exclusion, the subsidy given to state and local governments was less substantial because, again, the income tax was levied at a lower rate on a much smaller number of individuals. The import of the exemption has since exploded, along with its use.113 Again, the exemption did not emerge originally so much from a policy calculation, as from a political and legal one. In the 1960s, Congress became concerned that the tax exemption was in part being used to spur private endeavors that did not need a subsidy and perhaps were not even viable without one. At least some of the subsidy was also being used simply to generate positive arbitrage for state and local governments that were borrowing on the tax-exempt market and investing in the taxable market.114 It should be noted that, with each additional bond issued, the cost of this exemption to the federal government increased, while the benefit to the local entity decreased. This inverse relationship 112
There was a 90% drop in assessment revenue between 1930 and 1940 in cities with a population over 500,000. Donald C. Shoup, Financing Public Investment By Deferred Special Assessment, 33 NAT’L TAX J. 413, 413 (1980). 113 Zimmerman locates the explosion of debt issuance in the 1960s, see ZIMMERMAN, supra note 90, at 88. 114 For this history, see generally JCT, PRESENT LAW AND BACKGROUND RELATING TO STATE AND LOCAL GOVERNMENT BONDS (2006).
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between the cost and benefit of the subsidy is caused (in part) by the fact that the more tax-exempt bonds are issued, the lower the marginal tax bracket of the marginal tax-exempt bond buyer and so the greater the gap between how much money the federal government loses in the tax exemption relative to how much localities gain.115 Congress acted on the arbitrage concerns first in 1969; the primary rules, as we now know them, were passed as part of the Tax Reform Act in 1986.116 Congress acted first on the issue of private activity in 1968, with rules governing “industrial development bonds;” these rules also take their current form from the 1986 Act and the new term of art is that a bond to fund a private enterprise is a “private activity bond” (PAB) and it is more difficult for PABs to get the tax exemption.117 These changes have limited the issuance of tax-exempt bonds for the purpose of earning arbitrage and for subsidizing purely private businesses, but these practices have certainly not been eliminated, as the example below illustrates.118 Yet what this example illustrates most crucially is that Congress has not significantly limited the ability of state and local governments to trigger the federal financing subsidy to regional projects that should be of concern to the federal government. A mortifying symmetry has now long existed between the under-enforcement of 164(c)(1) and the leniency of the PAB regulations. What was supposed to happen – according to this observer - was that a taxpayer could not deduct her principal expense for special benefit assessments, just as a developer could not use taxexempt financing to build infrastructure for private developments. Yet because taxpayers ignore 164(c)(1) and Treasury has issued overly generous PAB regulations,119 developers are able to use taxexempt assessment financing to build the infrastructure for private 115
For more on the mechanics, see, for example JCT, supra note 114 at 7-8. I.R.C. § 148. 117 I.R.C. § 141; for more on these rules see Darien Shanske, Attention Carbon Auditors: There’s Low-Hanging Fruit in the PAB Regs, 127 TAX NOTES 693 (2010). 118 Many other examples are possible, notably there is the continued use of public funding to build stadium for private sports teams. See, e.g., Logan E. Gans, Take Me Out to the Ball Game, But Should the Crowd’s Taxes Pay for It?, 29 VA. TAX. REV. 751 (2010). 119 See generally Shanske, supra note 117. 116
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developments, and the new residents then deduct these assessments in total. Such use of speculative land-secured finance is widespread and has played a minor supporting role in the ongoing housingdriven economic crisis.120 Marrying the SALT deduction to the Section 103 tax exemption means that the federal government gave a double subsidy to many of the least advisable development projects. In sum, for a good part of the twentieth century, the federal income tax indifferently subsidized state and local taxes even as it was indiscriminately subsidizing state and local borrowing. By “indifferent,” I mean to emphasize the point made above that the federal government did not accord any special solicitude to subsidizing the property tax, even as the use of the property tax was declining. The “indiscriminate” use of the state and local financing subsidy primarily points to the fact that this subsidy was not directed to projects that should be of import to the national government. Yet the poor design of the subsidy was also was a missed opportunity to emphasize proper use of the property tax. Suppose, for instance, that the federal government had declared that it would only extend the tax exemption to state and local projects financed through property taxes levied in developed areas. I am not suggesting that such a policy would have been advisable (on its own).121 Nevertheless, by specifying that the tax exemption would be tied to the property tax, the federal government would presumably have given as big a bump to property taxes (if not bigger) than if it had limited the SALT deduction to property taxes. By adding the requirement that the exemption be used in “developed areas” to this possible reform I am just heading off the ability of states and localities to utilize the tax exemption on speculative projects. Again, I am not advocating this 120
See id.; see also Shanske, supra note 58 (arguing that the states themselves can and should bar localities from such practices). 121 One problem is that not all meritorious projects should be financed by the property tax – say a bridge to be financed by tolls or a wastewater treatment plant by fees. Yet this is not an insuperable obstacle. Such projects, for instance, could receive the tax-exemption (or BAB subsidy) if approved, for example, by the (proposed) National Infrastructure Bank. See H.R. 402, 112th Cong. (2011). The idea would be to limit state and local government initiative to projects that are property-tax based, but allow them to fund other kinds of projects only if there is some showing that the project is of the kind that the national government should be subsidizing.
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simple change without more, just noting that by making the tax exemption available to all kinds of projects and all kinds of financings – and all at the discretion of state and local governments the federal income tax made it easier for states and localities to shift away from traditional property taxes and to borrow sub-optimally. G. History and Salience: How to Proceed Prudently At the beginning of the Nicomachean Ethics, Aristotle instructs that “we shall be satisfied to indicate the truth roughly and in outline . . . the educated person seeks exactness in each area to the extent that the nature of the subject allows.”122 This is the rough approach appropriate to policy decisions as to what federal tax policy should be relative to the local property tax.123 There are many reasons for accepting that policy arguments can only be approximations in deciding what federal policy should be as to state and local revenue systems. Starting at the level of theory, as discussed in Part IV.B.2.a infra, the incidence of the property tax is far from clear. Because this is so, even if I did have a fine-grained theory of distributive justice such that I knew what the incidence of the entire federal-state-local tax system should be,124 I would not know exactly what role the property tax should play in such a system because I do not know its incidence. Further, there are variations across the country in the factors that influence incidence and also in citizen preferences not just as to the property tax, but as to the state-local tax system in general.125 Moreover, though it is indisputable that the use of the property tax has declined, it is also indisputable that this was for
122
ARISTOTLE, NICOMACHEAN ETHICS I.3 (Irwin translation). Cf. OATES, supra note 35, at 121 (following Richard Lipsey & Kelvin Lancaster, The General Theory of the Second Best, 24 REV. ECON. STUD. 11 (1956)). 124 And I do not, nor do I know of one, especially since such a theory would have to take into account the larger economic institutional background. See also, e.g., Linda Sugin, A Philosophical Objection to the Optimal Tax Model, 64 TAX L. REV., 229, 279-81 (2011). 125 Cf. H. F. Ladd & W.M. Gentry, State Tax Structure and Multiple Policy Objectives, 47 NAT’L TAX J. 747 (1994) (finding little support for uniform policy prescription for state tax structures). 123
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some good reasons, including revenue diversification,126 and so it does not make sense to argue for a return to a historical average, assuming we could agree on how to calculate that average. As a matter of economic history, the shift from the property tax was occasioned in part because less and less wealth was property based (at least in the sense of real property). Further, the property tax base has shifted to more and more residential property, as the economy has shifted from manufacturing (done in expensive industrial plants). This suggests that part of the decline in the relative import of the property tax can be connected to the increased pressure on one part of the property tax base (residential).127 Accordingly, the property tax revolts of the 1970s, like the property tax revolts of the 1930s, were connected to an increase in property taxes relative to the income of individual residential taxpayers.128 Yet this increase in the burden of the property tax was also caused by a host of contingencies. There was the high inflation of the 1970s129 and official inaction as to rising property taxes (particularly in California),130 coupled with the adoption of more stringent property assessment methods that made high inflation in property values particularly painful.131 There were specific California contingencies that contributed to Proposition 13, the first shot of the modern property tax revolt, particularly the demand of the California Supreme Court that California equalize the funding of its public schools. 132 Finally, Proposition 13’s advent itself encouraged 126
See, e.g., J.P. Suyderhoud, State-Local Revenue Diversification, Balance, and Fiscal Performance, 22 PUB. FIN. REV. 168 (1994) (finding improved fiscal performance associated with revenue diversification). Whether advisable or not, and at least partially in response to limitations in the property tax, local governments have followed states in diversifying their revenue sources, including to income and sales taxes. See Krane et al., supra note 108, at 525. 127 Gravelle & Wallace, supra note 104, at 37. 128 Wallis, supra note 106, at 178. 129 Nordlinger v. Hahn, 505 U.S. 1, 3-4 (1992) (Supreme Court emphasizes role of inflation). 130 Robert P. Inman, Financing Cities in A COMPANION TO URBAN ECONOMICS 311, 323 (Richard J. Arnott & Daniel P. McMillen eds., 2006) (noting in particular the paralysis caused by multiple overlapping entities). 131 ISAAC W. MARTIN, THE PERMANENT TAX REVOLT 25-49 (2008). 132 For the now classic argument that the California Serrano Supreme Court decisions caused Proposition 13, see FISCHEL, supra note 71, at 98-128. For a discussion of some of the other contingencies and observations on the limit of
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the adoption of dramatic property tax limitation measures in other states.133 Currently, the property tax is similarly under attack - most notably by the continuing dramatic drop in real estate value and, especially in certain areas of the country, the aging of the population.134 The connection between drops in real estate value and the unpopularity of the property tax should be clear; the connection with an aging population is that older taxpayers tend to be more liquidity constrained, thereby making the property tax a relatively greater burden. This liquidity issue touches on another aspect of historical contingency. The property tax is collected in a way that appears to maximize its political salience135 and, relatedly, its unpopularity. Specifically, the property tax is generally collected once or twice a year in lump sum payments.136 States and/or local governments could institute property tax withholding, but have not. The private sector, through tax escrow, provides taxpayers with essentially this service. Tax escrow means that a mortgage servicer is charging a portion of one’s property tax liability monthly along with one’s monthly mortgage payments. Many mortgagees pay their mortgages automatically. Fischel’s argument, see Darien Shanske, What the Original Property Tax Revolutionaries Wanted (It is Not What You Think), 1 CAL. J. OF POL. & POL’Y 18 (2009) (reviewing ISAAC W. MARTIN, THE PERMANENT PROPERTY TAX REVOLT: HOW THE PROPERTY TAX TRANSFORMED AMERICAN POLITICS (2008)). 133 Martin, supra note 131, at 108-20. And, it should be noted that Prop 13 particular solution to the liquidity problem – across-the-board assessment and rate limitation is “among the least effective, equitable, and efficient strategies available for providing property tax relief.” Terri A. Sexton, Assessment Limits as a Means of Limiting Homeowner Property Taxes in Augustine et al., supra note 104, at 117, 139. 134 See Shafroth, Hamilton, supra note 16. 135 “Political salience” refers, roughly, to the salience of a tax when voters make voting decision. This is in contrast to “market salience,” which refers to the salience of a tax when a consumer makes a market decision. David Gamage & Darien Shanske, Three Essays On Tax Salience: Market Salience and Political Salience, TAX L. REV. (forthcoming, 2012). Note the “appears.” As indicated supra at [_], the empirical study of salience is just beginning. 136 Joan M. Youngman, Property Taxation in TAX JUSTICE 223 (Joseph J. Thorndike & Dennis J. Ventry Jr., eds, 2002); Cabral & Hoxby, supra note 28, at 1.
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It could be objected that it is the property tax that is appropriately politically salient as is and that it is the federal income tax, because of withholding, that is not salient enough.137 However, determining the appropriate baseline for political salience is a vexed and ultimately intractable as a matter of tax policy. One large reason is that the benefits of government spending are not obviously more or less salient than taxation to voters, and so how do we know what the voters want as to taxing and spending?138 As for local property taxes, it can be responded that they in particular need to be visible, just like the benefits they provide are visible, such as one’s local public school.139 Thus, even if political salience is indeterminable at the national level, there should be a presumption at the local level that more salience is desirable. One might counter that the data suggests that voters hate the property tax even as they seem to like what it is being spent on and how (i.e., they like local governments - relatively), suggesting that the property tax is excessively despised because excessively salient,140 and it certainly seems to this observer that many local public goods are not particularly salient relative to local property taxes (e.g., traffic control, clean water). This debate can go on and on and is only relevant here to the extent it relates to whether the property tax has shriveled to the extent that it merits federal attention, and to that I think the answer is yes. Here is what I consider to be the analytic touchstones. First, as I have repeatedly emphasized, state and local finance systems have become so volatile that states and localities are having their role in the federal system undermined. Second, and more specifically, the property tax has attracted so much animosity that its ability to function as a benefit tax has been undermined. To see this second point requires going through a number of steps. First, it indeed makes sense to claim that the property tax must be relatively visible in order to operate as a benefit tax - that is, the 137
Such general concerns are summarized in Gamage & Shanske, supra note 135, at Part I.B.3. 138 See id. and Part III. 139 Brian Galle, Hidden Taxes, 87 WASH. U. L. R. 59, 96-97 (2009). 140 Cabral & Hoxby, supra note 28, at 21. Lilian Faulhaber would label this phenomenon “hypersalience.” Lilian Faulhaber, Hypersalience and Taxation, B. U. L. REV. forthcoming.
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voters opt for more or less property tax based on their preferences for local public goods. However, even proponents of the property tax as benefit tax concede that the tax revolts of the last decades have gone so far that in many cases the property tax cannot act as a benefit tax.141 In particular, strict property tax limitation regimes prevent local voters from modulating the property tax as they would like. Thus, whatever the plausible abstract arguments that the local property tax should be visible relative to the federal income tax, the current state of the tax indicates that there has been excessive turning away from the tax. In conclusion, we do not have a theoretical baseline for the property tax, and we cannot look to history for clear guidance. The decline in the property tax was (and is) related to major shifts in the economy and society; it would be foolish for the federal government to set itself against such trends. However, the historically and psychologically contingent aspects of this shift should be of concern to the federal government, especially to the extent that the decline in the property tax is tied to increased state and local fiscal volatility. It is against this backdrop that the arguments and proposals herein should be measured. The argument of this paper can be recast as follows: The decline of the property tax base is partially a result of contingent factors that have caused the property tax base to decline more than optimally.142 A change in federal tax policy could change
141
See discussion infra Part IV.B.2.a. The decline in the use of the property tax may be connected to another dynamic that may justify federal intervention: Baumol’s Cost Disease. Cost disease is a characteristic of certain labor intensive activities that cannot be made significantly and consistently more productive through the investment of capital. The classic example involves an orchestra. See generally W.J. BAUMOL & N.G. BOWEN, PERFORMING ARTS: THE ECONOMIC DILEMMA (1966). As many other goods and services have gotten far cheaper to produce (e.g., food and transportation), the investment required to have an orchestra perform a Beethoven symphony has changed little, and thus these labor intensive activities have become relatively more expensive. It has long been noted that many traditional government functions likely suffer from the cost disease; consider the labor involved in education or policing. W.J. Baumol, The Microeconomics of Unbalanced Growth: The Anatomy of Urban Crisis, 57 AMER. ECON. REV. 415, 423 (1967). Baumol himself went on to argue that local governments are going to have a particularly difficult time countering the cost disease because they simultaneously produce activities prone to cost disease and are less able to raise revenues – for instance 142
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the local property tax price slightly, thereby encouraging use of the local property tax. The story as to state and local use of debt is the mirror-image; by some hard to quantify amount states and localities are now overusing debt and federal policy should work to encourage prudence. With this pragmatic framing in place, we are ready to develop the arguments in favor of encouraging the use of the local property tax and cabining the use of the federal financing subsidy. IV. The Reform Proposal A. Outline of Proposed Reforms This paper proposes relatively small reforms that are politically feasible. By “small” I do not mean the scale of their potential impact; rather I am referring to the amount of institutional design that would be required.143 There are two broad areas for reform that I think should be pursued. I introduce the reforms in this sub-section so that I can justify them in the next. 1. Make the property tax primus inter pares Congress should reinstate a significant above-the-line deduction for the property tax, thereby giving more voters incentive to support the property tax (versus giving only itemizers an additional incentive to support the property tax). Concurrently, Congress should reduce the deductibility of other state and local taxes, perhaps eliminating the SALT deduction altogether.144 because of jurisdictional competition. Id. at 426. Thus Baumol concluded that the federal government should do more to aid local governments. Id. 143 Stark proposes a similar series of reforms. First, he would turn the SALT deduction into a credit and then he would scale the credit based on the underlying volatility of the tax. See Stark, supra note 13, 438-39. I have no objection to this more subtle series of reforms, but I think the simpler reforms advocated here, premised on resurrecting a tax provision that just expired, is more politically plausible (and still likely to be efficacious). 144 The CBO considered many SALT reform options in 2008, including a 2% ceiling and a $5,000 cap – both options would be an improvement. CBO, supra note 6 at 20-21. The CBO also considered limiting the deduction to just property taxes, which would also be an improvement, though not as much as also making property taxes deductible above the line. Id. at 22.
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As for Section 164(c)(1), which denies the SALT deduction for “taxes assessed against local benefits of a kind tending to increase the value of the property assessed,” I think this provision should be stricken completely.145 Failing that, the federal government should not expend valuable resources enforcing it, especially as to special assessments. The reason for this is that such benefit-based charges, which have been in decline for a century, have significant potential to stabilize local finances. 2. Better manage the federal financing subsidy. The SALT deduction serves to amplify the subsidy the Section 103 tax exclusion gives to state and local borrowing. For example, suppose a school district borrows ($100,000) for a new school and the current interest rate for municipal bonds is 7.5%. That means that the school district is paying (in the first year) $7,500 in interest. This interest income is excluded from the income of investors and deducted from the income of the school district’s taxpayers (under certain reasonable assumptions); we will assume that both have a marginal rate of 25% and so each the taxpayer and the investor save $1,875 (i.e., 25% * $7,500). The Section 103 exclusion has thus doubled the value of the SALT subsidy paid by the federal government. Seeing this connection indicates that the federal government ought to be all the more careful about monitoring Section 103 given that it is so cavalier in providing the deduction under Section 164. But this is not the case. Currently just about any state or local government project can benefit from tax-exempt bonds. The BAB program, which expired at the end of 2010, should be reinstated because at least the federal subsidy is paid directly to localities and so is more efficient than Section 103, which goes to taxpayers and indirectly to localities. However, I also think that the proposals made thus far do not make enough demands of states and localities. In particular, the federal subsidy is being used with little 145
Note that this is not to imply that typical user charges, such as for garbage pickup, should be deductible; such charges are not taxes and should not be deductible even without this provision (though that could be made clearer). What this provision bars – or seems to bar – is a deduction for most special assessment type land-secured financings of the kind that I argue should be encouraged.
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or no regard to whether a project is speculative, how it is funded, and whether the project in any way advances other federal goals, such as subsidizing projects with positive inter-jurisdictional spillovers. It is too late, probably, for the federal government to make such demands in connection with Section 103,146 but it is not too late in connection with the BAB program. Such narrowing of the subsidy is another modest nudge that the federal government can take to stabilize state and local finances. B. Justifying the Reforms I will now argue for my proposed set of reforms on three grounds: stability, efficiency, and equity. All of my arguments begin with the case for the property tax and end with the need simultaneously to adjust the financing subsidy if the gains from prioritizing the property tax are not to be diluted or even reversed. 1. Stability The relative stability of the property tax has held up, even during the current recession.147 There are several plausible reasons suggested by the literature. First, in general, a property’s assessed value (i.e., its value according to the county assessor) does not automatically reflect the property’s market value, making property values more stable when 146
But see, e.g., H.R. 2495, 112th Cong, §§ 523, 524 (2011) (Tax Equity and Middle Class Fairness Act of 2011 eliminates traditional tax exempt bonds and replaces them with lower-rate BABs). This bill is promising, though note that, even if passed, these new subsidized bonds would still not be directed towards any particular projects. 147 See, e.g., John L. Mikesell & Daniel R. Mullins, State and Local Revenue Yield and Stability in the Great Recession, 55 STATE TAX NOTES 267, 273 (2010); Byron Lutz et al., The Housing Crisis and State and Local Government Tax Revenue: Five Channels, at Figs. 2 and 4 and accompanying text (Finance and Economics Discussion Series Division of Research and Statistics and Monetary Affairs Federal Reserve Board, 2010); see also Byron F. Lutz The Connection Between House Price Appreciation and Property Tax Revenues, 61 NAT’L TAX J. 555, 567 (2008) (property tax revenues increase less than housing prices and decline much less than housing prices); Fred J. Giertz, The Property Tax Bound, 59 NAT’L TAX J., 695 (2006); HOLCOMBE & SOBEL, supra note 1, at 51.
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property values are unstable – that is, assessed values go up and down more slowly than market values. Sometimes this lag is a matter of local politics, sometimes it is a matter of law (as in California) and generally it just makes sense practically (how often can an assessor reassess property?). Again, a downturn in market prices does not automatically create a downturn in assessed values (and collections). To be sure, there does not need to be such a lag, but it is a common feature of property tax systems that is tied to how the tax is administered.148 Stability is a reason to support the continued existence of a lag, even if it could be eliminated administratively. If only states could create a substantial financial reserve, then big swings in their revenue bases would not be so problematic. The states have not been able to create such reserves. The simple explanation is politics – there are a lot of projects that the voters want and voters have limited patience for the “over” collection of taxes. But there is also an economic prediction problem, namely how much of a reserve is needed and when should it be spent.149 Creating a lag in assessing the property tax base creates a limited kind of reserve in case of economic downturn. This also moderates rapid increases in revenue when the property market is frothy. The second reason that property tax revenues appear relatively stable is that local governments can increase the tax rate as property values decline, and there is evidence that they do so.150 Of course, there are political limits to how much this can be done (and in California and many other states legal limits as well), but the point is that at least sometimes (and to some extent) rates can be slowly increased to keep revenue stable. If, as seems likely, a small increase in rates is macroeconomically preferable to a sharp decrease in spending during an economic downturn, then this adjustment 148
Assessed values do often eventually catch up with the market, making for serious fiscal challenges at the local level when prices are on their way down, though not challenges, it would seem to this observer, that cannot be planned for. See Shafroth, supra note 16. 149 See, e.g., David Scott Gamage, Coping through California’s Budget Crises in Light of Proposition 13 and California’s Fiscal Constitution, in AFTER THE TAX REVOLT: CALIFORNIA’S PROPOSITION 13 TURNS 30 (Jack Citrin & Isaac Martin eds., 2009). 150 Lutz et al. supra note 147, at 8.
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mechanism is a net relative positive for the property tax system as it is currently designed (in many places) versus the design of other taxes.151 This is not an absolute advantage of the property tax, but it is one that is true in practice and may well be related to the property tax itself to the extent it is a local benefit tax. Taxpayers are willing to pay taxes at a slightly higher rate for many typical local amenities, such as fire and police protection. In other words, property tax collections are more likely to remain stable since, as (partial) benefit taxes they pay for services for which demand is (relatively) inelastic. Third, property values are relatively visible and real property is immoveable. This makes it relatively easy to tax property, which is especially important for a local tax base given limited local resources. It is also important given the difficulties that localities have in taxing mobile residents and capital.152 A local government is thus particularly able to base its long-term budget on property tax collections (assuming the local government makes reasonable predictions). Furthermore, since the real property in a jurisdiction is immoveable and will to some extent impound the positive (and negative) value of government actions into its price, local property value is an appropriate concern of local government. In general, these are many of the reasons why the general theory of tax assignment allocates the property tax to local governments.153 Fourth, encouraging use of the property tax can encourage more stable local financing of capital projects. Property-secured levies underwrite financings of various kinds, particularly general obligation bonds that go towards local capital projects. These financings, in aggregate, represent a very sizable portion of our national investment in our capital stock and the federal government has an interest in their being done well.
151
This is the economic version of the equity argument (derived from Gamage, supra note 24) I develop below. 152 The relative administrative ease with which property can be taxed, and the reduced deadweight loss resulting from fewer opportunities to evade the tax also count towards the property tax’s efficiency. 153 See discussion Part II.C. supra. And, in fact, these are reasons why the property tax seems to have survived as well as it has despite its unpopularity. Cf. Edward A. Zelinsky, The Once and Future Property Tax: A Dialogue with my Younger Self, 23 CARDOZO L. REV. 2199, 2216-20 (2002).
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To the extent infrastructure financings are secured by stable revenue sources, like property taxes, but also user fees, then so much the better for these investments. Requiring that possibly selfsupporting projects, say a treatment plant (fees) or sewer line improvement (property assessments), actually fund themselves subjects the projects to market pressures and frees other resources – and in particular general taxes.154 Using general taxes for incomeproducing projects is not just potentially wasteful (because of the lack of market discipline in choosing projects), but destabilizing because these general taxes are relatively volatile. Infrastructure projects that can support themselves should not be held hostage to swings in state capital gains tax collections. So value-capture financing is to be preferred where possible, either through means of property-related levies (e.g., assessments) or fees that are essentially prices. But there is a dark side to valuecapture finance and that is speculation. The value to be captured might never materialize. This is part of the story of the collapse of assessment financing during the Great Depression. There may be a minor repeat of this history now in the Great Recession.155 The lesson here is that, at least as to property-secured financing mechanisms, care should be taken in their design ex ante. This is especially true because the federal tax system encourages the use of such financing mechanisms through the SALT deduction and Section 103. Replacing the property tax, even in its current diminished form, would require more than doubling state sales taxes.156 Contemplating the complete eclipse of the property tax should, I believe, concentrate minds. In order to better play its stabilization role, the federal government should nudge states to rely more on the local property tax. Simultaneously, and also consistent with its stabilizing role, the federal government should also act to nudge states and localities to better uses of debt. 154
Cf. MUSGRAVE & MUSGRAVE, supra note 46, at 196 (using benefit taxes can “eas[e] the pressure on general revenue finance”). 155 See e.g., Florida Community Development District Report, http://www.floridacddreport.com (last visited Jun. 30, 2011) (reporting 128 out of 600 of Florida assessment-type districts have defaulted as of early 2011). 156 Ronald C. Fisher et al., Implications of Eliminating the Property Tax in BELL et al. supra note 62.
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2. Efficiency As to efficiency, I am primarily following the argument of Shaviro: fiscal federalism works best with uniform tax bases. There are important arguments favoring the autonomy of sub-national governments in connection with how much money they raise and how they spend that money, but these arguments for fiscal federalism are much less convincing as to the specific chaos that is the current system. For instance, there is a strong argument for allowing local governments to utilize the property tax as they see fit because this tax can be most closely tied to the local benefits provided by that tax, but there is not nearly as strong an argument for every state (and local) government to choose a different set of tax bases, bases that are inconsistent with one another (e.g., which goods are exempted from the sales tax).157 I will not rehearse all of Shaviro’s arguments as to fiscal federalism, though there are two central points that I should like to emphasize. First, Shaviro does not believe that there is a strong argument for complete sub-national autonomy. For example, Shaviro is doubtful that the exit option, which is central to the analogy of many jurisdictions to a competitive marketplace, is either generally available or desirable.158 This is the analogue to the point made earlier about municipal bankruptcy159; local governments are often meaningful communities. Just as such communities ought not be liquidated, we do not want (or observe) individuals making locational choices between communities purely as a matter of economics. Second, Shaviro argues that the benefits jurisdictional competition may be able to deliver can be provided without wasteful competition over tax bases. Localities can compete over tax rates and expenditures. Having a uniform tax base could minimize the ability of states to engage in tax exporting and would also limit the administrative cost of doing business across states.160 Alas, notes Shaviro, if there were one such base, it might overly expose the
157
Shaviro, supra note 14, at 960. Id. at 964-65. 159 See Part II.C. infra. 160 Id. at 974. 158
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whole revenue system to fluctuation,161 but stability is the great strength of the property tax, and there is no suggestion that this be the only tax used by any level of government. Shaviro proposes uniform bases for all the major taxes, a proposal that I agree with and have little to add to,162 except to note that it seems unlikely to occur and that he shortchanges the property tax. As it is, the property tax has the most stable base and the property tax base is relatively uniform. Though Shaviro is surely correct that property taxes are compromised to the extent they are based on “subjective assessments” of value, the situation is not, I believe, as dire as he makes out.163 Especially with the aid of modern technology to look up comparable sales, assessments have become more sophisticated. Besides, many states have property assessment systems that resemble Shaviro’s preferred simplifications – i.e., original cost “plus a reasonable annual growth factor.”164 This is not to minimize the theoretical unsoundness of many aspects of the local property tax (such as the number of particularlistic exclusions),165 but it is to make the claim that deviations from the ideal should be seen as less problematic from the perspective of the federal government. Especially at its current relatively low level, I maintain that the deviations that plague the property tax are less severe than those that plague other common 161
Id. Id. at 979-85. 163 See supra Shaviro, supra note 14, at 982-83. 164 Id. at 983. Interestingly, the property factor under UDITPA (Uniform Division of Income for Tax Purposes Act) is even simpler, just original cost. UDITPA §13; CAL. REV. & TAX. CODE § 25130. Presumably, that is too simple for the general property tax. Shaviro notes that the major flaw in California’s approximation of his preferred system for the property is that its annual growth factor (2% in most instances) is too low; see Shaviro, supra note 14, at 983 n.322. Of course, as noted above, one (ironic) benefit of this design feature is to make California’s anemic property tax base a bit more stable. There is however no reason the growth factor could not be closer to the market rate without California losing the benefit of a lag for macroeconomic stability. Assessed values could be based on a multi-year rolling average, for instance. See Fisher et al., supra note 156, at 199. Note that California’s system mandates that a property be assigned a new assessed value when sold, meaning that the many properties bought in foreclosure sales in California are likely to have a very depressed assessed value for a long time. 165 John F. Witte, The Politics of the Property Tax Base, in AUGUSTINE ET AL., supra note 104, at 310-14. 162
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states taxes – particularly the sales tax and the corporate income tax.166 I can flush out this intuition in a number of ways and in a sense have been doing so all along. First, and foremost, as argued above, for all its flaws, the local property tax has been relatively stable and those reasons in part arise from the nature of the tax. Second, many of these deviations from the ideal are themselves “common”167 and in any event are still exceptions, meaning that the “Shaviro efficiency from uniformity argument” is still persuasive. Third, the local property tax is relatively easy to administer. Fourth, the property tax can be made better through federal government nudging and this paper in part aims to outline some avenues for nudging. Finally, as discussed below, the increased stability does have an underemphasized equity benefit. We should also not forget the related efficiency benefits that would result from better use of the federal financing subsidy. Most obviously, BABs deliver the full financing subsidy to state and local governments and make a wider market available, driving down the borrowing costs (for all levels of government). But the federal subsidy could also encourage states and localities to finance a smaller number of better projects, projects that, for example, are more likely to pay for themselves through enhanced land values. Like states competing for businesses and residents, in part on the basis of tax rates, states can compete for investment dollars on the basis of how much value their projects are likely to generate. As the market awards states with more businesses, it will reward states with good projects with lower interest rates.168 We should remember that, in many cases, this new more efficient BAB subsidy will reinforce 166
See, e.g., McLure supra note 38 and Kirk J. Stark, The Quiet Revolution in U.S. Subnational Corporate Income Taxation, 23 STATE TAX NOTES 775, 776 (Mar. 4, 2002). 167 Witte, supra note 165 at 310. 168 Right now the problem is not only that the federal subsidy is given indiscriminately, thereby dampening competition based on the quality of projects, but the municipal finance market is also problematically opaque, hindering the efficient allocation of capital. This is, manifestly, another area for reform. See generally Andrew Ang & Richard C. Green, The Hamilton Report: Lowering Borrowing Costs for States and Municipalities Through CommonMuni, (2011), available at http://www.brookings.edu/~/media/Files/rc/papers/2011/02_municipal_bond_ang_ green/02_municipal_bond_ang_green_paper.pdf.
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the new more efficient SALT subsidy, amplifying the efficiency of the federal government’s intervention in state and local finance. a. Whither Jurisdictional Competition (the Tiebout Model)? Though the argument I advanced in the stability section does suggest that the property tax has some benefit tax characteristics and I agree with Shaviro (and many others) that some jurisdictional competition can be advantageous, I am, as noted in Part II.D. supra, deliberately not grounding my efficiency argument on the property tax as purely a benefit tax. This is because, in general, I think the arguments in favor of using the federal income tax for stabilization are broader than the arguments for seeing the property tax as a benefit tax. Furthermore, I do not think that the property tax can usefully be characterized as a benefit tax at the national level, and so believe that the arguments from the benefit principle are limited as to formulating an appropriate national tax policy. For instance, even prominent espousers of the benefit view maintain that, in California, with its extreme property tax limitations (Proposition 13) and school equalization mandate (the Serrano series of decisions), the benefit view does not obtain (at least not strongly).169 That is, the quantity both of property taxes and the primary local public good (education) is set by state law and not by local voters. Given the number of property tax limitation regimes and school tax equalization schemes around the country,170 it is not clear how many states have property taxes that similarly undermine the benefit view. 169
See, e.g., FISCHEL, supra note 71, at 98-128. [I have also benefited from a presentation/unpublished draft paper on these points by William Fischel, Wallace Oates, and Joan Youngman]. 170 Nathan B. Anderson, Property tax limitations: an interpretive review, 59 NAT’L TAX J. 685 (2006) (forty-three of forty-eight states with property tax have a property tax limitation). Jeffrey Metzler, Inequitable Equilibrium: School Finance in the United States, 36 IND. L. REV. 561, 562-63 (2003) (“As of 1999, forty-three out of fifty states have faced legal challenges in state court alleging that the school finance system violated the state constitution's education or equal protection clause; twenty of these states have lost these challenges and been ordered to reform the education finance system. Furthermore, state legislatures have acted whether plaintiffs won or lost in court: since 1973 every state in the nation has passed some type of education finance reform.”) (footnotes omitted).
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But let us assume that just California has property taxes that are not benefit taxes and should therefore be deductible according to traditional income tax principles, but the entire rest of the country has benefit taxes, which should not be deductible. This still suggests to me that the right policy at the federal level is unclear given the size of California, but there is another big reason. Recent research171 indicates that the benefit view may be more or less accurate depending on circumstances other than the presence of property tax limitations or school finance equalization. In built-up suburban areas, the property tax seems to behave more like a benefit tax (e.g., parents are using the property tax as a partial substitute for tuition), but in more rural areas the property tax is just another tax on capital (i.e., if you invest in your property and make it worth more then you must pay more property tax). Reading these two qualifications together, we can say that the property tax operates like a benefit tax in relatively built-up urban areas so long as the state they are located in does not have too dramatic a property tax limitation and school equalization regime. Given this diversity, I do not see how these theories of the property tax as benefit tax can lead to sound tax policy for the whole nation, but this is not to say that there cannot be such a policy. Remember, we just argued that the nation would profit from localities utilizing a uniform tax base; this advantage is not dependent on determining to what extent the property tax is a benefit tax. There is also a dynamic political economy concern with embracing the property tax as a benefit tax simpliciter. The benefit view requires that property tax bills send property owners a strong market signal, including the signal that they should sell their home because someone else values it more. Let us assume that property taxpayers can receive this signal (i.e., that the property tax is suitably salient). Yet the history of property tax revolts strongly indicates that property taxpayers do not want to live in an uncompromising
171
Byron Lutz, Fiscal Amenities, School Finance Reform and the Supply Side of the Tiebout Market 28 (Finance and Economics Discussion Series Division of Research and Statistics and Monetary Affairs Federal Reserve Board, Sept. 21, 2009).
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benefit tax regime.172 One can adduce two persuasive reasons for this. First, individuals often attach significant subjective value to their homes and do not treat them solely as investments. Second, the signals sent by the market are liable to fluctuate considerably and, for external reasons (say ratings agencies with conflicts of interest), the signals might be inaccurate altogether. This indicates that the various property tax limitation regimes that hobble the property tax as benefit tax were not just some unfortunate act of God or result of an overly politically salient tax design, but the consequence of the property tax operating too much as an unfettered benefit tax. This suggests that, whatever reforms are crafted to resuscitate the property tax will only go so far as to transforming it into a pure benefit tax. All these concerns granted, there could be other related reasons for the federal government to prefer property taxes. First, if property taxes are benefit taxes, then the federal government can embrace them as encouraging positive jurisdictional competition. On this theory, the jurisdictional competition trumps the concern with distribution under a benefit tax regime perhaps because of the equity reasoning adduced in the next section or because the federal government is committed to mitigating the resulting inequality in some other way. But suppose property taxes are just taxes on capital (i.e., not a benefit tax),173 then the federal government can embrace the property tax as a relatively progressive local tax, and one that can be levied relatively efficiently compared to a tax on more mobile capital. This suggests that on either approach the federal government might learn to love the property tax. This is also true as to the traditional approach to the property tax – namely that it is a tax on land and a tax on the structures on the land. To the extent the property tax is a land tax – perhaps to a large extent given the lag in 172
The argument of this paragraph is elaborated upon in Darien Shanske, What the Original Property Tax Revolutionaries Wanted (It is Not What You Think), 1 CAL. J. OF POL. & POL’Y 18 (2009) (reviewing ISAAC W. MARTIN, THE PERMANENT PROPERTY TAX REVOLT: HOW THE PROPERTY TAX TRANSFORMED AMERICAN POLITICS (2008)). 173 G.R. Zodrow, The Property Tax As a Capital Tax: A Room with Three Views, 54 NAT’L TAX J. 139 (2001). Note that a key point made by Zodrow is that it is very hard to use empirical tests to distinguish his view, the capital tax view, from the benefit tax view, and this is another reason why national tax policy should not be based on the benefit view.
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assessments discussed above – then the property tax as land tax is particularly efficient because land taxes cause no economic distortion since land is in fixed supply (- no one will produce less land because of the tax).174 b. Conclusion on Efficiency Of course, the property tax is not just based on the value of land. Moreover, the property tax is not only a benefit tax and is not likely ever to be so. And, if the property tax is a tax on capital, then all the usual arguments against taxing capital can be mustered against the property tax. And so, though I do find Tiebout-type efficiency arguments suggestive, they are ultimately unsatisfying. I think the compelling efficiency reason for the federal government to prioritize the property tax is based on Shaviro – this is a relatively uniform tax base on which states and localities can compete on rate alone. 3. Equity There are three reasons why more stable state and local tax bases can help make our overall public finance system more equitable. First, because states generally operate under pro-cyclical balanced budget constraints, they are very likely to engage in damaging spending cuts just when greater spending is most needed. Second, because much state and local spending is hard or impossible to reduce (e.g., debt service), discretionary social spending bears a disproportionate burden of deep cuts.175 Finally, a small increase in tax rates is likely to be less destructive to individual or collective economic well-being than dramatic cuts to the social services that the least fortunate (and most credit constrained) depend upon.176 In the case of the property tax, we are not for the most part discussing an increase in rates (though that is possible) but a non-decrease of rates and/or assessed value that many property owners might experience as an increase given 174
Wallace E. Oates & Robert M. Schwab, The Simple Analytics of Land Value Taxation, in LAND VALUE TAXATION, 51, 58 (Richard F. Dye & Richard W. England eds., 2009). 175 Super, supra note 14, at 2632-33. 176 Gamage, supra note 24, at 785-90.
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their diminished resources during an economic downturn.177 Nevertheless, for most taxpayers, the small diffuse increase in taxes will be a much smaller burden relative to the increased concentrated burden on poorer citizens.178 There is also an important equity component to the parallel argument I have been making as to infrastructure finance. The most direct equity impact was implicit in the parenthetical point about debt service made above – if states and localities are paying too much on debt service because they have been encouraged to issue too much debt secured by general taxes, then there is going to be fewer dollars available for other services, as well as other projects. Furthermore, if projects that can sustain themselves are starved of stable funding, then they are more likely to be degraded. If one assumes that the more vulnerable are more likely to consume public goods, then in this way too improper state and local financing structures have equitable consequences. I will offer a somewhat detailed illustration of this point, one that also captures the interplay of the issues I am discussing. In 1978, Proposition 13 permanently cut the local property tax in California and made it difficult to impossible to raise property or property-related taxes, including, most importantly, for schools. The State of California stepped in to fill the void,179 but the State relies on income and sales taxes, with the result that the financing of California’s public schools is now much more volatile. If the proposals herein nudged more property tax financing of California schools then this would ameliorate this problem, presumably to the 177
Super, supra note 14, at 2637-38. Stephanie McMahon has observed (in conversation) that there is still a tradeoff here between equity and stability. For instance, some taxpayers will have their rates increased (or not decreased) who cannot afford it, while others who might be able to afford to pay more will not – it all depends on where they live. This worry reflects the fact that property taxes are not income taxes and so do not reflect ability to pay. Thus, without doubt, increased use of the property tax on its own does not increase equity (though reforms, like “circuit breakers,” can help). The point of this Article’s equity argument is that, viewed more broadly, the property tax does deliver equity benefits, benefits that can only be appreciated when one takes into account the volatility caused by the shift away from the property tax. 179 See generally Eric J Brunner & Jon Sonstelie, California’s School Finance Reform: An Experiment in Fiscal Federalism in THE TIEBOUT MODEL AT FIFTY 68 (William A. Fischel ed., 2006). 178
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gain of the least fortunate students disproportionately, as these are the students without the option to go to private school nor the option to move into wealthier school districts that can afford to insulate themselves to some extent from the woes of the State (e.g., through private foundations).180 Furthermore, even poorer California public schools do not wholly rely on the State, especially as to capital projects. School districts can propose school bonds to voters – and generally these bonds are to be paid back by an increase in local property taxes. This small exception to Proposition 13’s property assessment limit usually requires a 2/3 majority.181 Poorer communities have a more difficult time using such measures to finance their facilities, 182 a fact that the State recognizes and so the State makes available a financial hardship school facility funding program. Of course, relying on this state program only increases the dependence of school districts on state revenues, and this program is no sure thing, operates slowly, and has fairly onerous conditions (e.g., essentially that the school district has reached a point where it cannot issue any additional debt on its own).183 As an alternative to the statewide program, school districts can use their operating budgets to lease new facilities.184 Such financings do not require a vote and can be done quickly – these financings also qualify for the federal tax exemption. Leaving aside the wisdom and propriety of such financings, they do not sever the connection between school finance and volatile state revenue because California provides local school districts with the bulk of their operating budgets. To the extent that the State opts to cut school funding during a crisis, then, like the State itself, school districts must disproportionately cut relatively discretionary services 180
Brunner and Sonstelie, supra note 179, at 75-80. CAL. CONST. art. 13A, § (1)(b)(2). I discuss the exception to this exception, allowing for a 55% majority in Part V.A. infra. 182 SUSANNA LOEB ET AL., DISTRICT DOLLARS: PAINTING A PICTURE OF REVENUES AND EXPENDITURES IN CALIFORNIA'S SCHOOL DISTRICTS 54-55 (2006) (disparity in facility funding). 183 CALIFORNIA OFFICE OF PUBLIC SCHOOL CONSTRUCTION, SCHOOL FACILITY HANDBOOK, 71 (2008). Note that most of the programs under the school facility program require a local match. 184 CALIFORNIA DEBT AND INVESTMENT ADVISORY COMMISSION, CALIFORNIA DEBT ISSUANCE PRIMER, 126 (2005) (describing this financing mechanism). 181
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and not the share of their budgets going to servicing the debt on capital lease financings. If the federal government were to nudge the State to make it easier for all school districts to use property-secured financing for capital projects, then, again, poorer school districts seem likely to disproportionately benefit. It should be observed that such reforms would still leave the approximately 1,000 school districts in California to make infrastructure decisions which, under the current system, inevitably involves where the federal subsidy is to be spent. This is unfortunate, as it surely subsidizes projects that do not need the subsidy or projects that should not even be undertaken. If the federal subsidy were available only for projects that produce interjurisdictional benefits, then this would presumably redirect financing from infra-marginal projects in wealthier districts to higher priority projects in poorer districts. It is not hard to imagine a federal subsidy that could only be used for educational facilities in certain high priority areas; it is not hard to imagine because it already exists and could be expanded upon.185 a. An Objection An objector could point out that just because states and localities are in fact more likely to impose cuts that hurt the most vulnerable most does not mean that they should. The shift in federal policy advocated here suggests federal support, or at least connivance, in such cutting. The objector might maintain that, in contrast to mitigating unjust cutting on the part of the states, the best way to have a more just tax system is to have a tax collection system that is as just as possible, a tax expenditure system that is as just as possible, and a means of making needed adjustments that distributes any fiscal pain fairly. To this objection, I have two responses – one practical, one theoretical. First, the kind of wholesale changes to state (and federal) tax policy that this objector implicitly proposes are well beyond the incremental and pragmatic proposal that I am adopting 185
I.R.C. § 54E(d)(1)(D) (limiting the use of Qualified Zone Academy Bonds to schools in empowerment zones); I.R.C. § 1391 (process for designating empowerment zones).
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here. Second, this pattern of budget cutting is not necessarily avoidable, nor necessarily a product of political bias against the poor. To see this requires a multi-step argument. First, state and local tax systems are, as currently designed, very volatile,186 which means that some dramatic adjustments are occasionally unavoidable even beyond the adjustments required by the ordinary business cycle. Second, sub-national governments are not as strongly situated to effectuate redistribution as the federal government. Note that I am not taking the strong traditional position that there is no room for redistribution at the sub-national level. This is not the place to go over this debate in detail, but a few reasons not to accept the strong conclusion should be noted. First, there is the size of some subnational jurisdictions, like California. Second, there is heterogeneity in “taste” for redistribution. Third, this heterogeneity is in part a result of legitimate debate as to what is a redistributive program, what is a public good, and, specifically, what is a means of mitigating inter-jurisdictional externalities. I believe state-level school finance reform can be properly characterized in all of these ways. Fourth, as a matter of their own internal politics, states and localities do engage in redistribution and can “get away with it” precisely because there is not perfect mobility between states.187 In the end though, the consensus is surely sound that, because sub-national jurisdictions are in competition with one another to some extent for mobile residents and capital, taxes and programs that rely on a principle other than the benefit principle are more vulnerable to be cut. Thus, encouraging more state and local taxes to be collected according to the benefit principle serves to protect the increment of general taxes that can go to redistributive programs. If the programs that can take care of themselves are doing so (say tolls are paying for roads), then that leaves general tax dollars for those programs that cannot be entirely funded on a benefit principle, such as public schools. Even increased reliance on property taxes that are 186
And the volatility is connected to the states’s use of progressive income taxes and retail sales taxes that exclude food, which is to say that, at least to some extent, these revenue systems are volatile because of their commitment to distributive justice. 187 Cf., Roger Gordon & Julie Cullen, Income Redistribution in a Federal System of Governments (unpublished draft, 2010), http://www.nber.org/confer/2010/FFs10/Gordon_Cullen.
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not benefit taxes, but are stable for other reasons (e.g., the assessment lag), will obviate the need for the biting cuts that would otherwise be necessary. Of course, if it were possible to fund the large majority of government services with benefit taxes, then the small portion of general taxes collected – and the programs they fund – would be very vulnerable. To this concern, I again have two responses. The practical proposals of this paper are not going to effectuate that kind of radical change to state and local tax systems. And, in any event, given the diffuse commitments of modern governments, such as to public education, it is hard to imagine the benefit principle as anything but a small yet important complement to the ability to pay principle in practice. V. Refining the Reforms, Including a Proposal for Property Tax Withholding Let us now return to our proposed reforms: the primary reform is that the local property tax should be privileged. Congress should reinstate I.R.C § 63(c)(1)(C), i.e. make the property tax deductible above the line. This reform would give a greater number of state and local voters a stake in the use of the property tax because the property tax will have a “tax price” below one. The tax price refers to the amount a taxpayer will ultimately pay. Suppose a nonitemizer has a $1,000 property tax bill188 and has a marginal tax rate of 20%. With the above the line deduction, our taxpayer saves $200 in federal income taxes that should be netted against her $1,000 in local property taxes, for a total cost of $800, or a property tax price of .8. This hypothetical indicates that the reborn IRC 63(c)(1)(C) should not be based on the absolute value of the property tax, but on a percentage – say 75% deductible up to some ceiling indexed to inflation (say $3,000). The import of using a percentage is that otherwise the tax price will snap back to one if a taxpayer’s property tax bill is larger than the amount of the deduction (and the taxpayer does not itemize). 188
The national average was slightly over $1,000 in 2008. Francesca Levy, Where American Pay Most in Property Taxes (Jan. 15, 2010), http://www.forbes.com/2010/01/15/property-taxes-high-lifestyle-real-estatecounties-assessment-taxes.html.
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Nationally, the homeownership rate is 66.2%,189 while only 34% of taxpayers are itemizers.190 This suggests this reform could have a significant impact because almost twice as many taxpayers own homes as itemize.191 Even in a state like California, which has an above-average percentage of itemizers (about 38%) and a below average percentage of homeowners (56.9%),192 this reform would provide as many as 50% more taxpayers with a special stake in the property tax.193 The initial above the line deduction was estimated to cost the federal government a total of $2.4 billion for the two years of its existence.194 Let’s assume conservatively that the actual cost going forward will be as high as $2 billion/year.195 If the federal government doubled the deduction’s value, then it would cost $4 billion/year, which, it seems to this observer, can easily be raised through limiting the SALT deduction available for itemizers either directly or through the AMT or I.R.C § 68. Remember that this deduction is estimated to cost almost $75 billion/year and so the cuts needed to make my proposal revenue neutral are minimal, though the deductions for non-property taxes ($50 billion) are not serving a useful function and should be cut much more. If the federal income tax were to permanently allow an above the line deduction for property taxes, then the federal tax system 189
In 2009; see US Census Bureau, State & County Quickfacts: California. As of 2008; see Statistics of Income Division, I.R.S., All Returns: Adjusted Gross Income, Exemptions, Deductions, and Tax Items, classified by Size of Adjusted Gross Income and by Marital Status (Pub. 1304, Tax Year 2008), at tbl 1.2. 191 With several reasonable assumptions, such as that all homeowners are taxpayers. Note that it is not clear that all taxpayers should be analyzed as having equal influence on policy choices. ROBERT TANNENWALD, THE SUBSIDY FROM STATE AND LOCAL TAX DEDUCTIBILITY: TRENDS, METHODOLOGICAL ISSUES, AND ITS VALUE AFTER FEDERAL TAX REFORM (Federal Reserve Bank of Boston, 1997). That point granted, a doubling of the number of voters taking the deduction would surely have an impact, even if not in exact proportion to their numbers. 192 As of 2008, see Statistics of Income Division, supra note 190, at Table 2.1; Census Bureau, supra note 189. 193 This rough figure can be arrived at by comparing the percentages (i.e., 57% is 50% greater than 38%). 194 JCT, supra note 5, at 33. 195 This could be because we want the deduction to cost more because we want local taxpayers to raise more revenue through the property tax. 190
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would be in a position to lessen its withholding upfront. That is, if all taxpayers were entitled to the deduction no matter what, then there is no reason for the federal government to collect this money to begin with – if only the federal government knew how much individuals owed in property tax. And if only states were also withholding the property tax so that, in fact, the federal government was reducing withholding for property taxes that were actually being paid. The opportunity to have their citizens reduce their withholding ought to, one would hope, spur the states to adopt property tax withholding. If this proves not to be so, then we are now in a position to understand why the federal government should consider giving grants to encourage the states to create property-tax systems that have withholding that can then interact with the federal system. Voter anger with the property tax appears related to its excessive decline, and this excessive anger, as we saw, is likely in part related to how the property tax is collected. Lowering the tax price of the property tax is clearly a rational way to encourage its use, and that may well be sufficient. Yet making the collection of the property tax less onerous through withholding, likely saving administrative costs (after the initial capital investment), is a further means of mitigating the hatred of the property tax to the extent that hatred is not rational, but a result of its poor design. It could be objected that many states do not allow property taxes to be raised and thus these reforms will not accomplish much. As a question about official and voter behavior in connection with any of these reforms, this objection will be addressed in the next subsection. As a question about the legal landscape, this objection misconstrues these legal regimes. As far as I now, all states with property tax limitations regimes allow for voter overrides of some kind or another. In some cases, as in Massachusetts, the property tax override is explicitly labeled as such.196 In other states, such as California, the situation is more complicated, but voters can in effect override property tax limits.197 Perhaps more importantly, California (and all other states I know of) allows local governments to impose a host of other property-related taxes, including benefit assessments 196
MASS. GEN. LAWS ANN. ch. 59, §21C(g). CAL. CONST. art, 13A, § 1(b)(2), (3). In Massachusetts these would be called “capital expenditure exclusions.” MASS. GEN. LAWS ANN. ch. 59, §21C(k) 197
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and parcel taxes. It is precisely because some of these other kinds of taxes might be construed as non-deductible under Section 164(c)(1) that I think that this provision should be repealed (or explicitly narrowed to user charges). If property taxes and related levies are to be given a boost by federal tax policy, then we need to be especially concerned about the federal financing subsidy. We already know that this subsidy is not well designed or properly utilized; giving state and local government the incentive to issue more debt secured by more heavily subsidized property taxes is foolhardly, especially as concerns more speculative uses of land-secured financing. It would be ideal to eliminate the Section 103 tax exemption and reintroduce tax credit bonds (like BABs), but then limit the use of such bonds. Fundamentally, these bonds should only be available for projects of regional importance, perhaps as identified by a new National Infrastructure Bank. It would also be possible to use proxies for sound projects such as: only projects in developed areas, only projects in areas of high need or only certain kinds of projects. Current law provides models for such limitations.198 If it proves politically impossible to eliminate Section 103, then both Section 103 and the revived BABs should be limited in their use. If Section 103 cannot even be limited (the most likely prospect), then a new BAB program should be so limited and its subsidy rate should be set high enough (say 31%) that it attracts the best projects, thereby weaning states and localities off of Section 103. In the end, my proposals should be seen as consisting of two related tradeoffs, such that these reforms would not necessarily cost the federal government much (to the contrary!), but may have large impacts on the fiscal stability of states and localities. First, income taxes for many taxpayers can be lowered through increased property tax deductions, but other state and local taxes will have their deductibility reduced, thereby increasing total federal income taxes for some (likely higher income) taxpayers. Second, tax credit bonds will be reintroduced, but with greater restrictions on their use. The tax credit bonds may be more expensive for the federal government,
198
See, e.g., I.R.C. § 142 (defining “exempt facilities,” e.g., mass commuting facilities, for purposes of enabling tax exempt financing).
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but they will also be more efficient and may result in net savings if Section 103 is limited and/or eliminated. A. How Much Impact Can Federal Tax Policy Have? It is in the self-interest of states to organize their tax systems to maximize federal subsidies and so the proposed nudges herein should have some effect in theory,199 but it may seem unlikely that states and localities will actually act as rational maximizers. Starting with intuitions, one might believe that the strong concerns that voters have about rapidly inflating property taxes would not be dulled by the promise of deductions unless the deductions were very very large – thus tinkering with the federal tax system will not impact the use of local property taxes. I think this intuition has merit, but does not undermine the potential impact of these reforms. Remaining in the realm of relatively grounded intuition and anecdote, there are three channels by which federal tax policy impacts state and local taxes. First, state and local analysts and bureaucrats keep an eye on federal tax changes and make recommendations accordingly. As to the financing reforms I am advocating in particular, any changes to the federal tax system will be observed by expert administrators who do make (relatively) rational calculations – witness the rapid uptake of the BAB program. Yet the import of experts also holds for property taxes. For example, following the advice of a tax reform commission, in 2006, Texas cut property taxes by a third, planning that the resulting shortfall would be filled by state-level taxes, particularly a corporate income-type tax.200 This did not work out and a structural deficit emerged instead. It seems reasonable to this observer to surmise that the reform commission would have made a different recommendation if the property tax were privileged.201
199
See, e.g., Stark, supra note 13 at 438. Billy Hamilton, Raise My Taxes: A Modest, If Personally Expensive, Proposal, 60 STATE TAX NOTES 519 (May 16, 2011). 201 Granted the new business tax is likely deductible by the businesses themselves, but, leaving aside the ultimate incidence of these taxes, if the property tax were less toxic then perhaps the Texas legislature would have been less quick to cut property taxes. 200
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The second channel is similar. I have seen local government officials appeal to the deductibility of property taxes in order to convince local voters to approve bond measures secured by property taxes. To the extent that there is competition among state and local governments, explicit uptake would not need to be universal in order for there to be movement among many government entities. Third, taxpayers may learn of the improved deduction themselves, especially if the federal government advertizes the new deduction. A new opportunity to save on one’s federal taxes could be highly salient to taxpayers both in making market and political decisions. There is evidence that these channels (and others) have some impact on the structure of state and local finance.202 One of the best regarded and most relevant studies, that of Holtz-Eakin and Rosen, found that deductibility increased property tax rates by over 20%.203 Note that any shift to the property tax from other state or local taxes would amount to a gain in system stability. We can use numbers to make this point. Suppose that reinstating an above the line deduction for only property taxes increased property tax collection by 5% in California, which collects about $45 billion in property tax revenue.204 This would translate into approximately $2 billion in additional property taxes. If this is new revenue, then this relatively stable source of revenue contributes more than 20% to cutting California’s structural deficit, which was recently estimated to be a bit over $9 billion.205 If used to replace current revenue, then this $2 202
Kaplow, supra note 14, at 487-98 (surveying studies and finding evidence of some effect convincing); STEVEN M. MAGUIRE, FEDERAL DEDUCTIBILITY OF STATE AND LOCAL TAXES 4 (2007) (Congressional Research Service Rpt No. RL32781) (same). 203 Douglas Holtz-Eakin & Harvey S. Rosen, Tax Deductibility and Municipal Budget Structure in FISCAL FEDERALISM: QUANTITATIVE STUDIES 177 (Harvey S. Rosen ed., 1988); see also Martin S. Feldstein & Gilbert E. Metcalf, The Effect of Federal Tax Deductibility on State and Local Taxes and Spending, 95 J. POL. ECON. 710 (1987) (same but emphasizing substitution of other taxes); Howard Chemick & Andrew Reschovsky, Federal Tax Reform and the Financing of State and Local Governments, 5 J. POL’Y ANLY’S & MGMT 683-706 (1986). 204 CALIFORNIA LEGISLATIVE ANALYST’S OFFICE, CAL. FACTS 15 (2011), http://www.lao.ca.gov/reports/2011/calfacts/calfacts_010511.pdf. 205 See MATTHEW MURRAY ET AL., STRUCTURALLY UNBALANCED: CYCLICAL AND STRUCTURAL DEFICITS IN CALIFORNIA AND THE INTERMOUNTAIN WEST 6 (Brookings Mountain West, 2011), http://www.brookings.edu/papers/2011/0105_state_budgets.aspx.
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billion might be used, for example, to cut California’s capital gains tax by a substantial amount, thereby replacing a particularly volatile tax with a particularly staid one, making the next crisis that much less severe. The question immediately arises, again, as to just how property taxes are to be increased in California or in any of the many states with property tax limitation regimes. We have already noted the presence of override regimes, but this is still fairly vague as to the possible impact of the reforms we are discussing. California provides a more specific illustration. Overrides for capital projects in California usually require a 2/3 majority of voters, but since 2000 school districts only require a 55% majority (in many cases).206 In the first eight years since the 55% threshold became available, about $25 billion in new bond financing was approved that would not have been approved otherwise, for an average of about $3 billion per year of new financing.207 Making conservative assumptions about the terms of these bonds, the annual debt service when they are all outstanding will be about $1.6 billion.208 But the 55% threshold is only available to school districts for capital projects. Perhaps the proposed federal reform will nudge California to lower the threshold generally. But even if it does not, California local governments can still pass many other kinds of property-related taxes with a 2/3 vote and for operations as well as for capital projects. It does not seem unreasonable to suppose that increasing the number of taxpayers who can deduct the property tax by 50% could have an effect on the order of magnitude of lowering the threshold for approval from 66.6% to 55%.209 If this were so, then that would yield California significant new property tax revenues, which, again, would be enough to make some progress on California’s structural deficit and/or replace more volatile revenue sources. In making peace with modest goals, we 206
CAL. CONST. art. 13A, § (1)(b)(3). ELLEN HANAK, PAYING FOR INFRASTRUCTURE: CALIFORNIA’S CHOICES AT ISSUE 7-9 (Public Policy Institute of California, 2009), http://www.ppic.org/main /publication.asp?i=863. 208 Assuming a thirty-year term and 5% interest rate. 209 To be sure this is just speculation, surmising that relieving school districts of the burden of persuading roughly 11% more actual voters is comparable to providing the school districts with 50% more local voters who can be rationally appealed to on the basis of the increased deduction. 207
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should remember that it is likely that current system is doing more harm than good, and that the federal government can achieve such results while saving hundreds of billions of dollars over the next ten years. VI. Conclusion The federal government currently spends many billions of dollars subsidizing state and local governments through the tax system. These tax provisions were adopted in a scattershot manner and their impact is, accordingly, both diluted and arguably negative. In particular, the federal tax system has not responded as state and local tax systems have become more and more volatile. Indeed, by allowing for a deduction for progressive income taxes and subsidizing borrowing indiscriminately, the federal government may have, on balance, contributed to this growing instability. Given the fiscal pressure on the federal and state governments, the time has come for the federal government to rationalize the interaction of its tax system with state and local government finance. The states need to be encouraged to, once again, rely on the property tax as a stable source of local government funding. States and localities have also used debt sub-optimally, in part thanks to a poorly designed federal subsidy. Accordingly, this subsidy should be reformed. This Article has presented pragmatic incremental reforms that would advance federal goals, primarily the federal interest in stabilization. These reforms should not cost the federal government any more than it is currently spending through the tax system and would ideally result in much less federal expenditure.
