The Challenge of Tax Reform

11 Jun 2017 12:01 PM | Mike Lillich (Administrator)

By Oren Levin-Waldman

First published online by the Yonkers Tribune

As Congress takes up the GOP proposal for tax reform, some fundamental differences between red states and blue states will be put front and center. A huge difference between them is that blue states have higher tax burdens than do red states, and the cost of living in blue states tends to be higher, too. The blue state/red state divide is usually visible during presidential elections, but the GOP proposal to eliminate state and local tax deductions does again highlight that divide.

Eliminating the state and local tax deduction would result in blue state residents paying more taxes than red state residents. With the deduction, higher state and local taxes can be offset by a deduction that effectively reduces the federal liability. One way to look at the elimination of this deduction is that all taxpayers would be treated equally. Instead of blue state residents effectively paying lower federal taxes, they would now all be paying at the same rate.

Another way to look at it is that the elimination of the deduction does not treat people equally because states can still tax more than others. The deduction was but one way to equalize the differences. And yet, the differences raise some interesting constitutional issues. Under the American system of federalism, states are sovereign and can according to their respective laws, whether by statute or state constitution, impose taxes. The taxes they impose cannot be limited by the federal government.

The Equal Protection Clause of the Fourteenth Amendment, however, says that states cannot treat individuals differently. This is usually thought to mean that states cannot create invidious classifications between people. It has not meant that states are all required to have the same tax rate because not having the same rate would effectively be treating blue state residents differently from red state residents. That would involve a broader conception of the Equal Protection Clause, and one which has no real basis in American constitutional jurisprudence.

But that does not mean that politically speaking blue state residents are not being treated differently from red state residents. They are subject to higher taxes under the current system. If reform is passed, they will no longer have the federal deduction to mitigate those differences.

Perhaps the question we ought to ask is just what are the likely consequences of eliminating deductions? One possible consequence is more migration of both people and capital from blue states to red states because the taxes will indeed be lower. Of course this begs the question: have taxes in blue states been higher because of larger populations in need of services, or have they been higher because the deduction only encouraged blue state politicians to impose higher taxes?

In other words, might they have had higher taxes because they figured that with the deduction they would be little noticed by their residents? In other words, the deduction has meant that residents in red states have effectively been subsidizing blue states. To the extent that is true, the deduction may have also been distorting state spending priorities because politicians simply assumed that they could raise their taxes and the deduction would simply mitigate the additional pain they may have experienced.

Still, one wonders why blue state residents may have been content to pay higher taxes when they simply could have left to go to red states. After all, red states, compared to blue, have lower costs of living and lower levels of income inequality.

If we borrow from public choice theory we might gain a bit of understanding into why blue state residents have been willing to pay higher taxes. The basic premise, as put forth by Anthony Downs in An Economic Theory of Democracy sixty years ago is that each person and or group is a rational actor acting according to self interest. Individuals vote on the basis of which candidate and/or political party will best serve their interests. Public officials seeking to be elected also pursue policies that serve their’s.

Because wealthier people are more likely to participate and contribute to political campaigns, public officials are more likely to put their interests over those of everybody else. But because poor people can band together, their interests cannot simply be ignored. Therefore, public officials will purchase the quiescence of those at the bottom with programs that might increase their money utility. This then frees public officials to pursue those policies favored by the wealthy. In essence the money utility of all is increased at a cost to all.

This idea has become the basis of the median voter theorem put forth by Alan Meltzer and Scott Richard. According to the Meltzer-Richard construct, the greater the distance between the median voter’s income and society’s average income, the more inequality there is. In response to growing inequality, public officials will opt for redistribution in order to stave off the potential for violence. The median voter is effectively choosing the rate of taxation for the purposes of redistribution.

States that have higher taxes may be purchasing the quiescence of low-income voters with programs, but pursuing other policies favorable to the rich. Both groups are increasing their money utility. The federal tax deduction no doubt helps public officials to do this at the state and local level. In other words, it may be that voters in these states are opting, as counter-intuitive as that may seem, for higher taxes.

Why would the median voter opt for higher taxes? Why similarly would the blue state voter? Because the blue state voter expects to get something in exchange that boosts his money utility. So too does the median voter. If we understand what is going on, we can now understand why tax reform with a few flat tax rates and absolutely no deductions is almost an impossibility despite the fact that such an approach might be more in the public interest.

Those on the left have been calling for more taxes on the wealthy is response to growing income inequality. This is certainly assumed by the median voter theorem. But to boost the tax rates of the wealthy does not really mean they will be paying more taxes because they have enough deductions to offset the higher marginal tax rates the left would gladly impose. Not only do they serve their money utility interests, but they have the added bonus of appearing to speak the language of the public interest: compassion for the poor.

Simply put, tax reform is not in their interests and it certainly isn’t in their interests if they are high tax blue states. And yet, all of this rent seeking — the seeking of personal advantage — is ultimately contrary to the public interest. What is the effect of this? To distort voting generally. To distort spending priorities. To distort democracy altogether. One does not support policy because it is in the public interest, but because there is a payoff.

The tax code in all its complexity has become a means to distribute goods to all that come along at a cost to us all. The federal tax deduction for state and local taxes is effectively a payoff to blue states who are further incentivized to spend money on programs because the deductions allow them to raise taxes. In the end, tax reform will be difficult, if not altogether impossible to achieve.

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