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Earlier this week, the Institute on Taxation and Economic Policy released a new report, Topsy-Turvy: State Income Tax Deductions for Federal Income Taxes Turn Tax Fairness on its Head. The report highlights an unusual tax break that currently exists in only six states (Alabama, Iowa, Louisiana, Missouri, Montana, and Oregon): a state income tax deduction for federal income tax payments. Collectively these states stand to lose over $2.5 billion in tax revenues in 2011 due to these tax breaks, with losses ranging from $45 million to $643 million per state.
Unfortunately, the high price tag of this tax giveaway yields remarkably little benefit to low-and middle-income families. In states where the deduction is uncapped, the best off 1 percent of taxpayers enjoy up to one-third of the benefits from this provision, while the top 20 percent enjoy up to 80 percent of the benefits. Wisely, several states have eliminated or scaled back this expensive and poorly targeted deduction in the last few years. North Dakota, Oklahoma, and Utah have all eliminated the deduction, and Oregon lawmakers voted recently to further limit their deduction.
Deductions for federal income taxes seriously undermine the adequacy and fairness of state income taxes. These deductions also leave state budgets vulnerable to changes in federal tax law. As the recession lingers and states look to enhance their long term fiscal solvency, elected officials in states with a deduction for federal income taxes paid have a real opportunity to close fiscal shortfalls in a way that has minimal impact on low-and middle-income families.