Income Tax Deductions for Sales Taxes: A Step Away from Tax Fairness

Sales taxes are the biggest tax fairness problem facing state and local governments: they inexorably fall hardest on the low-income families who are least able to pay them, while asking far less, as a share of income, from the very best-off taxpayers. So if the federal government enacts a tax break designed to offset the impact of sales taxes, that can’t be a bad thing, right? As it turns out, it IS a bad thing, as explained in a recent report from Citizens for Tax Justice.

A deduction for sales taxes existed in the past but was repealed as part of the loophole-closing Tax Reform Act of 1986. In 2004 Congress brought the concept back as the itemized deduction that federal income taxpayers can claim for state and local sales taxes they pay each year.

Spearheaded by then-House Majority Leader Tom DeLay, the provision, enacted as part of the “American Jobs Creation Act of 2004,” gave itemizers the choice of deducting either their state and local income taxes or their sales taxes. The provision was set to expire two years later–and that’s how it joined the big happy family of “tax extenders,” the motley crew of temporary tax giveaways Congress now extends every couple of years.

Almost a decade later, the sales tax deduction is once again set to expire at the end of 2013. However, the deduction has a vocal fan base among politicians in the nine states that have no broad-based income taxes and rely more on sales taxes to fund public services. Since these states include large states like Florida and Texas, it’s a constituency that is difficult to ignore. Their Congressional delegations argue that it’s unfair for the federal government to allow a deduction for state income taxes, but not for sales taxes, but this misses the larger point. The underlying problem with sales taxes is their impact on low-income families, and itemized deductions don’t help low-income people, who mostly take the standard deduction rather than itemizing. Also, the higher your income, the more the deduction is worth, since the tax benefit depends on your income tax bracket.

The table above includes taxpayer data from the IRS for 2011, the most recent year available, along with data generated from the Institute on Taxation and Economic Policy (ITEP) tax model to determine how different income groups would be affected by the deduction for sales taxes in the context of the federal income tax laws in effect today.

As illustrated in the table, people making less than $60,000 a year who take the sales-tax deduction receive an average tax break of just $100, and receive less than a fifth of the total tax benefit. Those with incomes between $100,000 and $200,000 enjoy a break of almost $500 and receive a third of the deduction, while those with incomes exceeding $200,000 save $1,130 and receive just over a fourth of the total tax benefit.

So the sales tax deduction is both complicated and regressive, not to mention an added burden on the vast majority who don’t use it but have to pay for it (in the form of higher tax rates or skimpier public services). Yet too many of our politicians seem to think “other than those flaws, what’s not to like?”

The good news is that all Congress has to do in order to make this bad dream end is… nothing. Since the tax break is set to expire on New Year’s Day, Congressional tax writers can achieve a small, but meaningful, victory for tax fairness and simplification by simply sitting on their hands.