Capitol Hill Flirts with Reviving Sales Tax Deduction

Taxpayers in seven states are being used as bait to gain support for a major corporate federal tax package pending on Capitol Hill.

The U.S. House passed a giant corporate tax bill June 17 (HR 4520) that includes a proposal to allow taxpayers in states without income taxes to instead deduct sales taxes from their federal taxable income. The deduction could lower federal tax bills for citizens in Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming for two years — 2004 and 2005.

Sources on and off Capitol Hill say the temporary state tax break was included as a sweetener to attract more support for the overall bill, which would cut tax rates for U.S. manufacturers while it eliminates export subsidies that have been ruled illegal by the World Trade Organization.

A U.S. Senate-passed version of the corporate tax bill does not include the state sales tax deduction, so it’s unclear whether it will become law this year. The House and Senate haven’t taken any steps yet to reconcile their differences on the measures.

However, the House action has revived hopes of restoring the federal deduction for state and local sales tax, a tax break that was eliminated in 1986. The idea is drawing mixed reviews. Most state lawmakers like the idea, but groups from different sides of the political spectrum are giving it a thumbs down.

Technically, the measure would allow taxpayers in all states to choose between deducting states sales taxes or state income taxes on their federal tax returns. Under current law, state income tax already can be deducted. Because a person typically pays more in income taxes than sales taxes, taxpayers in states without income taxes are the ones who would benefit under the proposal.

Nine states impose no income tax, but among those, Alaska and New Hampshire also don’t have sales taxes so are unaffected.

Advocates of reinstating a sales tax deduction say the current federal tax code is unfair to states without income taxes because it allows taxpayers in 41 states to reduce their federal tax burden by deducting state and local income taxes. The best way to remove this inequity, supporters say, is to allow states without income taxes to deduct state and local sales tax.

“The enactment of the sales tax deductibility provision has been a long-standing goal of the National Conference of State Legislatures,” Pennsylvania state Rep. David Steil (R), chair of NCSL’s Budgets and Revenues Committee, said in a statement. “The inclusion of the deductibility provision in this legislation is a major victory for state taxpayers.”

The impact of a sales tax deduction would extend beyond the seven states without income taxes, argues Chris Atkins, director of tax and fiscal policy for the American Legislative Exchange Council (ALEC), an organization that describes itself as representing conservative state lawmakers. ALEC also supports the proposal.

Atkins said that reinstating the sales tax break would help states that want to move away from income or property tax and toward the sales tax. States would be able to overhaul their tax systems without making their citizens feel as if they were losing their tax breaks while paying higher taxes.

For example, Atkins said, imagine a state that eliminates its income tax and imposes a sales tax. Taxpayers would lose their federal deduction for paying state income taxes, and they cannot deduct their sales taxes under current federal law. That would result in a significant federal tax increase for the taxpayer. “Restoring sales tax deductibility would alleviate this problem,” Atkins said.

But other groups contend a sales tax deduction is a bad idea. The Center on Budget and Policy Priorities, a group that studies policies that affect the poor, said the sales tax deduction proposal largely would benefit high-income taxpayers.

The tax break could be used only by those who itemize their tax deductions, a group that tends to be the well off, the center’s Nick Johnson said. For example, seven of every 10 residents in Texas and Tennessee don’t itemize, so they would save nothing under the proposal, he said.

The Heritage Foundation, a conservative think tank, says a state sales tax deduction would be bad policy because it “shields taxpayers from the full burden of tax increases,” making it easier for state and local politicians to boost sales tax rates. The Heritage’s Daniel J. Mitchell said a better idea is to eliminate all federal deductions for state and local taxes, particularly income taxes.