Bridging the Gap (2): Closing the circle on the state income tax deduction

As Oklahoma faces record budget shortfalls, the threat of massive cuts that would slow the state’s economic recovery and have potentially devastating effects on schools, social services, and public safety loom large. In this context, there is an urgent need for a balanced approach to bridging the state’s budget gap that includes identifying possible sources of additional one-time or ongoing revenue. This post is the second in a series that discusses some of the most promising policy ideas for generating additional revenue that would go at least part of the way to closing the budget deficit; the first looked at the sales tax discount paid to vendors.

Were you aware that Oklahoma allows a state income tax deduction for state income taxes? The idea doesn’t sound plausible, but it’s true.  Among the allowable deductions for those who claim itemized deductions on their federal taxes is one for state income tax. In 2007, according to IRS statistics (Excel file),  about 400,000 Oklahomans claimed this deduction to the tune of $2.2 billion. Due to a quirk of Oklahoma tax laws, those deducting state income taxes from their federal taxes are also allowed to claim this deduction against their state income tax.

Oklahoma is one of just six states – the others are Arizona, Hawaii, Louisiana, Rhode Island and Vermont – that allow the deduction of state income tax on state tax returns.  Most states that allow taxpayers to carry over federal itemized deductions on their state return require taxpayers to simply add back the state income taxes deducted at the federal level.  And the few states that don’t already follow this sensible practice are catching on: New Mexico recently enacted legislation to end the deduction, while Vermont has capped the deduction at $5,000.

The fiscal impact report prepared by the New Mexico Taxation and Revenue Department for the bill doing away with this deduction identified the core problem:

Allowing the deduction merely reduces the effective rate of state income tax for taxpayers who itemize. This policy provides ease of compliance for taxpayers, but one consequence is a reduction  in the effective income tax rate for households that itemize deductions relative to households that do not itemize.

In practice, as the Table shows, allowing the deduction of state income taxes reduces taxes primarily for the wealthy. A full 67 percent of the deductions for state income taxes claimed by Oklahomans in 2007 were claimed by the 8 percent of taxpayers with income over $100,000. By contrast, while 73 percent of Oklahoma taxpayers had income under $50,000, only 12 percent of this population itemized their deductions and they accounted for just 10 percent of the amount deducted for state income taxes.

Eliminating the deduction for state income taxes would bring in $118 million in additional revenue to the state, according to an analysis conducted by the Institute for Taxation and Economic Policy. Three out of four Oklahoma households – those who claim the standard deduction – would be unaffected by this tax change. Just 4 percent of the additional state revenue from this change to the tax code would come from the 60 percent of taxpayers with income below $49,100, while 58 percent of the additional revenues would be borne by the wealthiest 5 percent of taxpayers, those with incomes above $163,000 in 2011.   (However, for those paying more, the impact of higher state income taxes would be partially offset by lower federal taxes, since those state taxes would remain federally deductible).

The circular process that allows state income taxes to be claimed as a deduction against state income taxes makes little sense and benefits only the minority of mostly wealthier Oklahomans who itemize their deductions. Doing away with this loophole would mark an important step towards a more equitable tax system, but more importantly, would improve our chances of navigating through these perilous fiscal straits without causing severe and irreparable harm to vital public services.