As Oklahoma faces a more than $600 million budget hole, state leaders have consistently said that “all options should be on the table.” With state services already straining from years of repeated cuts and flat funding, a balanced approach to closing the budget gap must include new revenues. One of the fairest and most sensible revenue options involves eliminating one of the most nonsensical quirks of our tax system – the state income tax deduction for state income taxes.
In all states with an income tax, taxpayers who itemize their federal tax deductions can claim a deduction for what they paid in state income taxes. Almost all states that allow taxpayers to carry over federal itemized deductions to their state tax return require them to add back the deduction for state income taxes. Oklahoma is one of just six states – the others are Arizona, Hawaii, Louisiana, Rhode Island and Vermont – that still allows the deduction of state income tax on state tax returns.
The deduction for state income taxes primarily benefits higher-income Oklahomans, since wealthier households are far more likely to itemize their deductions. Only 1 in 10 households with income under $50,000 itemized their deductions in 2012, compared to 95 percent of those with income above $200,000, according to federal IRS tax return data from 2012. Taxpayers with incomes above $200,000 a year represent less than 3 percent of all Oklahoma households, yet they claimed a full 75.4 percent of the deduction for state income taxes, as can be seen from the chart below. Conversely, almost two-thirds of Oklahoma households (65.7 percent) have income under $50,000, yet this population accounted for just 6.8 percent of the deduction for state income taxes. In fact, the 88 percent of Oklahomans with income under $100,000 in 2012 together accounted for just 16.5 percent of the deduction for state income taxes.
Oklahoma could also exclude the deduction for local property taxes from state income taxes. In other states, the property tax deduction can help offset the burden of high property tax assessments, but in Oklahoma, which has among the lowest property taxes in the nation, this purpose is less compelling. The income tax deduction for property taxes also provides greater benefit to higher-income households, but not as disproportionately as the income tax deduction. Some 56 percent of the deduction for property taxes went to households with incomes over $100,000 in 2012, compared to 14.8 percent for those with incomes below $50,000.
Eliminating these deductions would provide a significant revenue boost. Disallowing just the deduction for state income tax would yield the state $97 million, according to an analysis by the Institute for Taxation and Economic Policy. Only one in four households (24 percent) would be affected at all by this tax change. Over half of the $97 million in new revenue – 58 percent – would be paid by the wealthiest 5 percent of taxpayers (incomes over $200,000), while just 3 percent would be paid by the 60 percent of taxpayers with incomes below $59,800. If the deduction for local property taxes were included, the revenue gain would rise to $132.0 million, but low- and moderate-income households would pay a somewhat higher share of the total tax.
In recent years, there has been a push to do away with the deduction for state income tax as part of efforts to adopt revenue-neutral tax reform. Elimination of the state income tax deduction was part of the final tax agreement between the Governor and legislative leadership in 2012 that ultimately failed to gain passage. Last year, two tax cut bills passed out of the Senate Finance committee that included doing away with the state income tax deduction, which the authors referred to as “double dipping.”
Ultimately, last year the Legislature passed a cut to the top income tax rate without paying for it through any reductions in tax breaks. The income tax cut, which will take effect in January despite projections that state revenues will fall, is contributing to the budget shortfall and offers substantial benefit to the wealthiest households but little or nothing to most Oklahomans. Doing away with the deduction for state income taxes, which would raise desperately needed revenue for critical services and affect only a minority of mostly affluent households, would be an appropriate and responsible offset to last year’s tax cut while providing the state with critical revenue that could avert deeper cuts to education, health care, and other essential services.