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Posts Tagged ‘State and Local Taxes’

Politicians who preach class warfare repeatedly assert that we need higher taxes on “the rich.”

Indeed, that’s been the biggest political issue (and oftentimes biggest economic issue) in every recent tax fight (the Trump tax reform and Obama’s fiscal cliff), as well as the issue that generates the most controversy when discussing tax reform.

So it seems almost inconceivable that the class-warfare crowd would support a change to the tax code that would only benefit the top-10 percent, right?

Yet that’s exactly what’s happening in the fight over the deduction for state and local taxes.

Democrats want to restore an unlimited deduction, thereby enabling people to shield more of their income from tax. But, as the Tax Foundation notes, that change only produces benefits for upper-income taxpayers.

Itemized deductions such as the SALT deduction are mostly utilized by higher-income individuals. As such, any change to the SALT deduction will chiefly impact them. In addition, the value of a deduction increases as a taxpayer’s statutory tax rate increases. A deduction against the top rate of 37 percent is more valuable than a deduction against the 32 percent tax rate. We estimate that eliminating the SALT deduction cap would have no impact on taxpayers in the bottom two income quintiles and a negligible impact on taxpayers in the third and fourth quintiles. …However, taxpayers in the top 5 and 1 percent of income earners would see an increase in after-tax income of 1.6 percent and 3.7 percent respectively.

And if restoring the deduction is “paid for” by raising the corporate tax rate, the net effect is to raise taxes on the bottom-90 percent in order to give a tax to top-10 percent.

Or, to be more precise, to give a tax cut to the top-1 percent.

Some of you may be thinking that the Tax Foundation leans right and therefore can’t be trusted.

So let’s look at some research from the Tax Policy Center, which is a joint project of the left-leaning Urban Institute and left-leaning Brookings Institution.

Only about 9 percent of households would benefit from repeal of the Tax Cuts and Jobs Act’s (TCJA) $10,000 cap on the state and local property tax (SALT) deduction, and more than 96 percent of the tax cut would go to the highest-income 20 percent of households… For all middle-income taxpayers, the average tax cut would be $10. Those in the top 1 percent would pay an average of $31,000, or 2 percent of after-tax income, less.

And here’s the TPC chart showing how almost all the tax relief goes to upper-income taxpayers.

So what’s going on? Why are Democrats fighting for an idea that would give the rich a $31,000 tax cut while only providing $10 of relief for middle-class taxpayers?!?

The simple answer is that they think the loophole is a very valuable way of facilitating higher taxes and bigger government at the state and local level. And they’re right, so I don’t blame them.

But it’s nonetheless very revealing that they are willing to jettison their tax-the-rich rhetoric when it interferes with their make-government-bigger agenda.

P.S. This “SALT” debate strikes me as being similar to the Laffer-Curve debate, which requires folks on the left to choose whether it’s more important to punish rich people or to get more revenue to spend.

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The right kind of tax reform can help people directly and indirectly.

  • They benefit directly if reform reduces their tax burden and gives them more take-home income.
  • They benefit indirectly if reform increases growth and leads to additional pre-tax income.

For what it’s worth, I think the indirect impact is most important for family finances, and I discussed the potential benefits of faster growth in this recent interview on Fox Business.

But for today’s column, I want to focus on the final portion of the interview, when I pontificated on how limiting the state and local tax deduction is going to motivate some successful taxpayers to “vote with their  feet” and therefore put additional pressure on high-tax states.

And if we get lower tax rates at the state level, we can include that outcome as another indirect benefit of federal tax reform.

I’m leery of predictions, but I think this will happen. The bottom line is that high-income taxpayers – even before tax reform from Washington – have been escaping from states such as Illinois and California. Here are some fun facts from a recent column in National Review based on IRS data.

Last month, the Internal Revenue Service released the latest tax and migration numbers for 2015 and 2016. …the latest figures show that Florida is seeing an overwhelming influx of taxpayers from other states. In 2015 and 2016, the Sunshine State attracted a staggering net inflow of $17.4 billion in adjusted gross incomes. …the IRS is able to break down new residents by age groups. During the 2015–16 reporting period, nearly 70,000 tax filers between the ages of 26 and 35 moved into the state. That age group accounted for the biggest influx of new Florida residents, over ten thousand more than the 55-and-over category. …The states that lost the most net taxpayers in both dollar and percentage terms relative to their existing tax bases are Connecticut (–$2.7 billion) and New York (–$8.8 billion). What does this tell us? …the size of a state’s government matters. Florida’s per capita state spending is the lowest in the country… Connecticut, meanwhile, has the eighth highest per capita state spending, and New York ranks 15th. …New York has the second heaviest aggregate tax burden of any state, while Florida’s is the fourth lightest.

The Daily Caller combed through some new data from the Census Bureau.

Three Democratic-leaning states hemorrhaged hundreds of thousands of people in 2016 and 2017 as crime, high taxes and, in some cases, crummy weather had residents seeking greener pastures elsewhere. The exodus of residents was most pronounced in New York, which saw about 190,000 people leave the state between July 1, 2016 and July 1, 2017, according to U.S. Census Bureau data released last week. …Illinois lost so many residents that it dropped from the fifth to the sixth-most populous state in 2017, losing its previous spot to Pennsylvania. Just under 115,000 Illinois residents decamped for other states between July 2016 and July 2017. Since 2010, the Land of Lincoln has lost about 650,000 residents to other states on net… Illinois’ Democratic-dominated legislature has tried to ameliorate the situation with tax hikes, causing even more people to leave and throwing the state into a demographic spiral. Illinois experiences a net loss of about 33,000 residents in 2016, the fourth consecutive year of population decline. …California was the third deep blue state to experience significant domestic out-migration between July 2016 and July 2017, and it couldn’t blame the outflow on retirees searching for a more agreeable climate. About 138,000 residents left the state during that time period, second only to New York.

Even the establishment media is noticing.

Here are excerpts from a recent report in the Mercury News.

A growing number of Bay Area residents — besieged by home prices, worsening traffic, high taxes and a generally more expensive cost of living — believe life would be better just about anywhere else but here. During the 12 months ending June 30, the number of people leaving California for another state exceeded by 61,100 the number who moved here from elsewhere in the U.S., according to state Finance Department statistics. The so-called “net outward migration” was the largest since 2011, when 63,300 more people fled California than entered. …”They are tired of the state of California and the endless taxes here,” said Scott McElfresh, a certified moving consultant. “People are getting soaked every time they turn around.”

And now that state and local taxes will no longer be fully deductible, this out-migration is going to accelerate. Which, of course, will mean added pressure for lower tax rates in states like New York and California. And New Jersey, Illinois, and Connecticut.

Here are some excerpts from a story from Yahoo Finance.

Wall Street tax expert Robert Willens, president of Robert Willens LLC, has never heard more discussion from wealthy New Yorkers about relocating to another state with a more favorable tax environment until now because of the GOP tax plan. “Everybody I speak to brings this up. Every NYC resident I speak to asks about the feasibility involved in doing it,” Willens, who regularly advises hedge fund clients on tax matters as it relates to investing, told Yahoo Finance. “I’ve been doing this more than 40 years, and never heard more discussion about relocating than recently.” …“He believes it will devastate NY (and, to a lesser extent, CA), primarily by ending or severely limiting the deduction of the very high state and local taxes. He estimated that his tax rate (and others [similarly] situated) will go from mid-30% to 56%, which will trigger a massive exodus from NY to places like Florida, which will crush the NYC (and therefore state) economy.” …Kelly Smallridge, the president and CEO of Palm Beach County’s Business Development Board, has seen an uptick in activity from CEOs looking to explore Florida since there’s no state tax on personal income. …The move from the northeast to Florida has been somewhat of a trend in recent years. In the last five years, 60 financial services firms have relocated to the Palm Beach area, Smallridge noted.

If you want to know what states are most vulnerable, the Tax Foundation’s map of state income tax burdens is a good place to start. Also, the Tax Foundation’s State Business Tax Climate Index is another measure of which states over-tax their citizens.

And here’s a survey of small business sentiment that shows which states are viewed as having unfriendly tax codes. Green is good and orange is bad.

And it’s also worth reviewing the evidence that already exists for tax-motivated migration.

Here’s a map showing the entire country and here’s a map showing the exodus from California.

Let’s close with this amusing cartoon strip.

Very clever. Sort of reminds me of these two cartoons (here and here) on the economic rivalry between Texas and California.

P.S. The folks at Redpanels, by the way, also have produced great cartoons on Keynesian economics, communism, the minimum wagebasic income, and infrastructure.

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I’ve written a couple of times to explain why the deduction for state and local taxes should be eliminated as part of pro-growth tax reform.

One of my main arguments, as I pointed out at the beginning of this interview, is that Republicans are generally unwilling to finance pro-growth tax changes by restraining government spending.

And since GOPers are too timid on spending, that means “revenue offsets” are needed to finance the good provisions in tax reform (assuming the goal is to make such changes permanent).

But this second-best approach can still be very good if the right loopholes are targeted.

In other words, wiping out the deduction is a good idea as a general principle, but it’s a very good idea in today’s environment since it would produce a lot of revenue to “offset” the cost of lowering tax rates and making our awful tax system less onerous. Plus, the deduction is unfair and inconsistent with principles of good policy.

Many organization point out that generating revenues by getting rid of the state and local deduction would be a win-win situation.

The National Taxpayers Union is not a fan.

…the provision departs from principles of sound tax policy and unwisely abets the behavior of high-tax states, enabling big government.

And the Heritage Foundation doesn’t like the loophole.

The deduction for state and local taxes creates winners and losers within states. Higher-income taxpayers win; lower-income taxpayers lose.

The Tax Foundation has weighed in.

The deduction favors high-income, high-tax states like California and New York, which together receive nearly one-third of the deduction’s total value nationwide.

Along with the American Enterprise Institute.

…repealing the state and local tax deduction would be an important move toward broadening the tax base.

Americans for Tax Reform also opposes the deduction.

…this deduction actually subsidizes upper income earners in high tax states.

And the Center for Freedom and Prosperity has a fact sheet with lots of data.

…nearly all filers (~99.7%) would likely benefit from a lower rate and increased standard deduction notwithstanding the loss of SALT.

National Review rejects the loophole.

Getting rid of state-tax deductibility is…good policy. …deductions mainly benefit higher-income households. …The federal government…should not use the tax code to encourage or discourage.

But the most powerful and persuasive evidence for getting rid of the deduction is that organizations favoring higher taxes and bigger government openly admit that the loophole encourages and enables bad policy (what they would call good policy) at the state and local level. You don’t have to believe me. Here are some passages from a report by the Center for Budget and Policy Priorities.

…with this deduction, higher-income filers are more willing to support state and local taxes. …Ending the SALT deduction would strain state budgets over time by making it harder for states and localities to raise…revenues… The GOP tax plan…would threaten many states’ ability to raise…revenue.

What’s amazing is that the report openly acknowledges that the deduction overwhelmingly benefits the wealthy, something that CBPP normally doesn’t like because of their support for class-warfare taxation.

But if one’s goal is bigger government, you acquiesce to reverse class warfare when it makes life easier for tax-aholic politicians in states such as CaliforniaConnecticutIllinoisNew York, and New Jersey.

The lesson for the rest of us, though, is that if CBPP thinks this preference for the rich is worth preserving, the rest of us should want it abolished.

Let’s close with some analysis that is compelling to me. Here’s what Ronald Reagan said when he tried to eliminate this odious loophole back in the 1980s.

P.S. I still prefer the first-best option of tax reform financed by spending restraint. If Republicans simply limited federal spending so it grew by 1.96 percent per year over the next 10 years, that would enable both a balanced budget and a $3 trillion tax cut. And that’s even with static scoring!

P.P.S. Back during the debate on tax reform in the 1980s, Reagan also opposed the VAT. Helps to explain why I admire the Gipper so much.

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The federal income tax is corrosive and destructive. It’s almost as if a group of malicious people decided to deliberately design a system that imposes maximum damage while also allowing the most corruption.

The economic damage is not only the result of high tax rates and pervasive double taxation, but also because of loopholes that exist to bribe people into making economically unwise decisions.

These include itemized deductions for mortgages and charitable contributions, as well as the fringe benefits exclusion and the exemption for municipal bond interest. And there are many other corrupt favors sprinkled through a metastasizing tax code.

But there’s a strong case to be made that the worst loophole is the deduction for state and local taxes. Why? For the simple reason that it encourages, enables, and subsidizes bad policy.

Here’s how it works. State and local lawmakers can increase income taxes or property taxes and be partially insulated from political blowback because their taxpayers can deduct those taxes on their federal return.

And it’s a back-door way of giving a special break to upper-income taxpayers because the deduction is more valuable to people in higher tax brackets.

Let’s look at an example that’s currently in the news. Democrats in the Illinois state legislature want a big increase in the personal income tax. If they succeed and boost taxes by an average of $1000, high-income taxpayers who take advantage of the deduction may only suffer a loss of as little as $600 since their federal tax bill may fall by almost $400.

For politicians, this is an ideal racket. They can promise various interest groups $1000 of goodies while reducing take-home pay by a lesser amount.

Let’s review some recent commentary on this topic.

The Wall Street Journal opined on the issue last weekend.

Chuck Schumer aspires to raise taxes on every rich person in America, save one protected class: coastal progressives. …Like many other Democrats, he’s apoplectic about a plan to end the state and local tax deduction. …One goal of tax reform is to reduce unproductive tax loopholes, and ending the state and local deduction would generate revenue to finance lower rates: The deduction is worth about $100 billion a year… About 88% of the benefits in 2014 flowed to taxpayers who earn more than $100,000, while 1% went to those who earn less than $50,000. California alone reaps nearly 20% of the benefit…and a mere six states get more than half. …The folks underwriting this windfall are in Alaska, South Dakota, Wyoming and other places without a state income tax. …Eliminating the deduction would be a powerful incentive for Governors to cut state taxes on residents who are suddenly exposed to their full liability. …killing the state and local deduction would pay a double dividend: The first is creating a more equitable tax code with a broader base and lower rates. The second is spurring reform in states that are long overdue for a better tax climate.

Writing earlier this year for National Review, Kevin Williamson was characteristically blunt.

It’s time for…blue-state…tax increases that would fall most heavily on upper-income Americans in high-tax progressive states such as California and New York. …eliminate the deduction for state income taxes, a provision that takes some of the sting out of living in a high-tax jurisdiction such as New York City (which has both state and local income taxes) or California, home to the nation’s highest state-tax burden. Do not hold your breath waiting for the inequality warriors to congratulate Republicans for proposing these significant tax increases on the rich. …allowing for the deduction of state taxes against federal tax liabilities creates a subsidy and an incentive for higher state taxes. California in essence is able to capture money that would be federal revenue and use it for its own ends, an option that is not practically available to low-tax (and no-income-tax) states such as Nevada and Florida. It makes sense to allow the states to compete on taxes and services, but the federal tax code biases that competition in favor of high-tax jurisdictions.

And Bob McManus adds his two cents in an article for the Manhattan Institute’s City Journal.

Voters in all heavy-tax, high-spending states have no one to blame for their situation save themselves. At a minimum, it seems clear that deductibility—by softening the impact of federal taxation—encourages outsize state and local spending. States that take advantage of deductibility—mostly in the Northeast and on the West Coast—are in effect subsidized by states that have kept tighter control on their spending. …New York’s top-of-the-charts spending puts the state at the pinnacle…with New Yorkers paying a national high of 12.7 percent of income in state and local levies. Local property taxes in New York are astronomical and not coming down any time soon. …deductibility has powerful friends—among them the public-employee unions… New York and the nation would benefit if deductibility was jettisoned. …end the incentive for the tax-and-spend practices that have been so economically corrosive to big-spending Blue states.

Let’s close with the should-be-obvious point that the goal isn’t to repeal the state and local tax deduction in order to give politicians in Washington more money to spend. Instead, every penny of that revenue should be used to finance pro-growth tax reforms.

That creates a win-win situation of better tax policy in Washington, while also creating pressure for better tax policy at the state and local level.

For what it’s worth, both Trump and House Republicans are proposing to get rid of the deduction.

P.S. I mentioned at the start of this column that it would not be unreasonable to think that the tax code was deliberately designed to maximize economic damage. But even a curmudgeon like me doesn’t think that’s actually the case. Instead, our awful tax system is the result of 104 years of “public choice.”

P.P.S. Itemized deductions and other loopholes create distortions by allowing people to understate their income if they engage in approved behaviors. There are also provisions of the tax code – such as depreciation and worldwide taxation – that force taxpayers to overstate their income.

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If I had to pick my least-favorite tax loophole, the economist part of my brain would select the healthcare exclusion. After all, that special preference creates a destructive incentive for over-insurance and contributes (along with Medicare, Medicaid, Obamacare, etc) to the third-party payer crisis that is crippling America’s healthcare system.

But if I based my answer on the more visceral, instinctive portion of my brain, I would select the deduction for state and local taxes. As I’ve previously noted, that odious tax break enables higher taxes at the state and local level. Simply stated, greedy politicians in a state like California can boost tax rates and soothe anxious state taxpayers by telling them that they can use their higher payments to Sacramento as a deduction to reduce their payments to Washington.

What’s ironic about this loophole is that it’s basically a write-off for the rich. Only 30 percent of all taxpayers utilize the deduction for state and local taxes. But they’re not evenly distributed by income. Here’s a sobering table from a report by the Tax Foundation.

The beneficiaries also aren’t evenly distributed by geography.

Here’s a map from the Tax Foundation showing in dark blue that only a tiny part of the country benefits from this unfair loophole for high-income taxpayers.

As you can see from the map, the vast majority of the nation deducts less than $2,000 in state and local taxes.

But if you really want to see who benefits, don’t simply look at the dark blue sections. After all, most of those people would happily give up the state and local tax deduction in exchange for some of the other policies that are part of tax reform – particularly lower tax rates and less double taxation.

And I suspect that’s even true for the people who hugely benefit from the deduction. The biggest beneficiaries of this loophole are concentrated in a tiny handful of wealthy counties in New York, California, New Jersey, and Connecticut.

As you can see, they reap enormous advantages from the state and local tax deduction, though I suspect these same people also would benefit if tax rates were lowered and double taxation was reduced.

Regardless of who benefits and loses, there’s a more fundamental question. Should federal tax law be distorted to subsidize high tax burdens at the state and local level?

Kevin Williamson of National Review says no.

…the deduction of state taxes against federal tax liabilities creates a subsidy and an incentive for higher state taxes. California in essence is able to capture money that would be federal revenue and use it for its own ends, an option that is not practically available to low-tax (and no-income-tax) states such as Nevada and Florida. It makes sense to allow the states to compete on taxes and services, but the federal tax code biases that competition in favor of high-tax jurisdictions.

The Governor of New York, by contrast, argues that the tax code should subsidize his profligacy.

It would be “devastating on the state of New York, California, et cetera, if you didn’t allow the people of this state to deduct their state and local taxes,” Cuomo told reporters… State and local governments have been working to preserve the deduction, and they argue that doing away with the preference would hurt states and localities’ flexibility to make tax changes.

By the way, I noticed how the reporter displays bias. Instead of being honest and writing that that the loophole enables higher taxes, she writes that the loss of the preference “would hurt states and localities’ flexibility to make tax changes.”

Gee, anyone want to guess how that “flexibility” is displayed?

Though at least the reporter acknowledged that the deduction is primarily for rich people in blue states.

…the deduction…is viewed as disproportionately benefiting wealthy people. It also tends to be used in areas that lean Democratic.

And that’s confirmed by a 2016 news report from the Wall Street Journal.

Repealing the federal deduction for state and local taxes would make 23.6% of U.S. households pay an average of $2,348 more to the Internal Revenue Service for 2016. But those costs—almost $1.3 trillion over a decade—aren’t evenly spread… Ranked by the average potential tax increase, the top 13 states (including Washington, D.C.), as well as 16 of the top 17, voted twice for President Barack Obama. …And nearly one-third of the cost would be paid by residents of California and New York, two solidly Democratic states. …President Ronald Reagan tried repealing the deduction as part of the tax-code overhaul in 1986, but he was rebuffed by congressional Democrats and state officials. …Republicans argue that the break subsidizes high state taxes, because governors and legislators know they can raise income taxes on their citizens and have the federal government pick up part of the tab. …half the cost of repealing the deduction would be borne by households making $100,000 to $500,000, using a broad definition of income. Another 30% would be borne by households making more than $1 million. Under the GOP plans, residents of high-tax states wouldn’t necessarily pay more in federal taxes than they do now. They would benefit from tax-rate cuts.

Here’s one final image that underscores the unfairness of the deduction.

The Tax Policy Center has a report on the loophole for state and local taxes and they put together this chart showing that rich people are far more likely to take advantage of the deduction. And it’s worth much more for them than it is for lower-income Americans.

How much more? Well, more than 90 percent of taxpayers earning more than $1 million use the deduction and their average tax break is more than $260,000. By contrast, only a small fraction of taxpayers earning less than $50 thousand annually benefit from the deduction and they only get a tax break of about $3,800.

Yet leftists who complain about rich people manipulating the tax system usually defend this tax break.

It’s enough to make you think their real goal is bigger government.

I’ll close by calling attention to the mid-part of this interview. I shared it a couple of days ago as part of a big-picture discussion of Trump’s tax plan. But I specifically address the state and local tax deduction around 3:00 and 4:30 of the discussion.

P.S. In addition to the loophole that encourages higher taxes at the state and local level, there’s also a special tax preference that encourages higher spending at the state and local level. Sigh.

P.P.S. Now, perhaps, people will understand why I want to rip up the current system and replace it with a simple and fair flat tax.

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I have a handful of simple rules for good tax policy.

  • Keep government small, since it’s impossible to have a reasonable tax system with a bloated welfare state.
  • Keep tax rates low to minimize penalties against income, production, and wealth creation.
  • Since capital formation is critical for long-run growth, don’t double-tax income that is saved and invested.
  • Eliminate corrupt and distorting loopholes that encourage people to make decisions that are economically irrational.

Some of these principles are interrelated. I don’t like loopholes in part because of the reasons I just listed. But I also don’t like them because politicians often claim that they need to boost tax rates to make up for the fact that they lose revenue due to various deductions, credits, exemptions, and preferences.

And sometimes a deduction in the tax code even leads to bad policy by state and local government. Today, I want to discuss preferences in the internal revenue code for state and local taxes. And I’m motivated to address this issue because some of the politicians on Capitol Hill have pointed out an inequity, but they want to fix it in the wrong way.

Under current law, state and local income taxes are fully deductible, but state and local sales taxes are only temporarily deductible. The right policy is to get rid of any deductibility for any state and local tax. But since that would create a windfall of new tax revenue for the spendaholics in Washington, every penny of that revenue should be used to lower tax rates.

Not surprisingly, the crowd in Washington doesn’t take this approach. Instead, they want to extend deductibility for the sales tax. And they may even be amenable to raising other taxes to impose that policy.

Here are some excerpts from a story in The Hill.

More than five dozen House members are pressing leaders of a tax panel to preserve a deduction for state and local sales taxes. The bipartisan group of lawmakers say it would be unfair to voters in their states not to extend the sales tax deduction, given that taxpayers would still be able to deduct state and local income taxes. …Eight states in all — Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington and Wyoming — currently use a sales tax, but either don’t have or have a very limited state income tax. …The letter comes as many lawmakers hope to finish off an extenders package once Congress returns to Washington after November’s elections. Lawmakers will have to grapple with expiring Bush-era tax rates — just one part of the so-called fiscal cliff — when they return, and tax extenders could be tacked on to a broader package. The Senate Finance Committee has already passed an extenders package of its own, which included a two-year extension — at a cost of an estimated $4.4 billion over a decade — of the sales tax deduction.

I have some sympathy for these members of Congress. They represent states that have wisely decided not to impose income taxes, yet the federal tax system rewards profligate high-tax states such as New York and California with a permanent deduction for state and local income taxes.

This is a very misguided policy. It means that greedy politicians such as Governor Brown of California or Governor Cuomo of New York can raise tax rates and tell voters not to get too upset because they can deduct that additional burden. This means that a $1 tax hike results in a loss of take-home pay of as little as 65 cents.

This is what a fair tax code looks like

But you don’t cure one bad policy with another bad policy. A deduction for state and local sales taxes just augments the IRS-enforced preference for bigger government at the state and local level.

The right answer is the flat tax. Put in place the lowest-possible tax rate, which is feasible because all loopholes are wiped out.

In the case of state and local tax deductibility (or lack thereof, with any luck), that’s a win-win-win situation.

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