Reminder: there’s no upside for blue states in comprehensive tax reform

Make no little plans. They have no magic to stir men’s blood and probably themselves will not be realized. Make big plans; aim high in hope and work, remembering that a noble, logical diagram once recorded will never die, but long after we are gone will be a living thing, asserting itself with ever-growing insistency. Remember that our sons and grandsons are going to do things that would stagger us. Let your watchword be order and your beacon beauty. Think big. -Urban planner Daniel Burnham

Dave Camp’s long-awaited, much-respected, almost-certainly-dead-on-arrival tax reform plan contains several items of immediate interest for state and local governments.

  • Municipal bond interest (Sections 1001-3): “certain tax preferences could only be taken against the 25-percent bracket, but not the 35-percent bracket,” one of which is interest on municipal bonds. This effectively “appl[ies]a new 10% surtax on municipal bonds,” making them less appealing to investors, and thus increasing state and local governments’ cost of borrowing. It appears that this surtax would apply to interest on both new and existing issues, although any pain associated with limiting the tax exemption on old bonds would be felt by the investor, not the government borrower. Camp also wants to repeal the tax exemption for private activity bonds on a going-forward basis, which would strike a big blow against crony capitalism at the state and local level.
  • Enterprise/Empowerment Zones (Sections 3821-3823): Camp advocates scrapping this old urban revitalization idea, aptly described by Bruce Bartlett as “a good idea that was worth trying and just didn’t work.” Proposing to put the enterprise zone concept out of its misery is kind of interesting in light of Sen. Rand Paul’s recent proposal to breathe new life into it.
  • State and local tax deduction (Section 1405): no longer could high earners deduct their state and local taxes from their federal income tax bill. “The provision would eliminate a tax benefit that effectively subsidizes higher State and local taxes and increased spending at the State and local level.” As I discuss in this report, high tax blue states stand to lose big from this proposal.

The plan has two main selling points. First, it would have an enormously beneficial economic impact: $3.4 trillion in output and 1.8 million jobs, according to the Joint Committee on Taxation. Two, it would result in a simpler tax code, “25% simpler,” in Camp’s estimation. In terms of the experience of individual filers, Camp offers less complexity mostly in the form of a big expansion of the standard deduction ($11,000 for individuals, $22,000 for couples, up from $6,100 and $12,200). Currently, more than a third of filers itemize their deductions. Under the Camp plan, about 5% would.

Camp’s plan is, over the long term, revenue neutral. It’s not a tax cut, or it is for some but not others. Families of four making the national median $51,000 would pay $1,300 less in income taxes. But high earners, while their top rate would drop by four points, would be hit hard by only being able to deduct interest on $500,000 of mortgage principal on new loans, losing their ability to deduct their state and local tax burden entirely, and, for finance industry professionals, seeing their carried interest taxed as ordinary income, instead of capital gains.

Which brings me back to the blue states. The Camp plan helpfully reminds us how wedded blue states are to the tax code’s hopelessly complex status quo. “Tax reform,” in common parlance, means dropping rates and making up the revenues through closing loopholes. Dropping rates costs a lot of money. Camp’s rate reductions would lose almost $550 billion in revenue over the next decade. So the only realistic way to finance a rate cut is to go after the largest exemptions and deductions. Many of those happen to be most valuable to blue state taxpayers. A tax reformer determined to hold harmless the home mortgage ($110 billion in FY14 according to the Office of Management and Budget) and state and local tax deductions ($85 billion) would have a much harder time meeting the “revenue neutral” standard. It would probably be futile. And if tax reform has to mean actual tax relief for the middle class (hard to see how it gets much traction if it doesn’t), Wall Street and others in the top earning cohort, who tend to be concentrated in blue states, will likely have to endure some inconvenience.

The state and local tax deduction reduces the real cost of government in blue states by about 30%. That’s how much it shields high earners from the real bite of the non-Federal taxes imposed on them by state and local politicians. If blue states want to keep their good thing going, they have to oppose comprehensive tax reform, because it’s just impossible to see how they would come out ahead in the end.

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