Camp Tax Reform Would Create New Challenges for States

House Ways and Means Chair Dave Camp’s recent tax reform plan would raise the cost of doing business for many state and local governments.

Camp would repeal the deductibility of state and local taxes, including both property taxes and income taxes. He’d abolish tax-exempt private activity bonds. And he’d impose a 10 percent surtax on municipal bond interest for high-income households, a step likely to raise the cost of issuing state and local debt.

But Camp’s plan also includes some less obvious changes that could increase state income tax revenues, especially for states that piggyback on the federal income tax. By limiting deductions—and thus boosting taxable income—Camp’s plan could also increase state income tax revenue, just as the Tax Reform Act of 1986 did.

Here is a brief summary of the state and local provisions in Camp’s plan:

Repeal of the state and local tax deductions. In 2011, itemizers deducted $470 billion of state and local taxes they paid. Camp would repeal the deduction for state and local income taxes, and for real property taxes. Only the personal property tax, usually related to business equipment, would remain deductible in most cases.

For states with income taxes, the deduction is a federal subsidy. The state gets the revenue, but the filer may deduct state income tax against his federal obligation. The real property tax deduction reduces the cost of home ownership for mostly high-income households who are more likely to itemize and subsidizes local governments that rely on property tax revenue.

Tax municipal bonds. In 2011, state and local governments issued $171 billion of debt and 4 million filers reported $62 billion of tax-exempt interest. Camp would deny the deduction of muni bond interest against the 10 percent surtax on high-income taxpayers. That would limit the value of the preference to 25 percent, close to the 28 percent limit President Obama has repeatedly proposed in his budgets. The Tax Policy Center estimates about 80 percent of the explicit benefit of the current exemption goes to these households. Limit the tax subsidy and state and local governments might face higher interest rates to sell as many tax-exempt bonds as they do today.

Tax private activity bonds and advanced refunding bonds. PABs are used by state and local governments to finance privately owned projects that have an ostensible public use, such as nursing homes and some real estate projects. Today, each state may issue a limited number of these bonds based on the size of its population. In 2011, state and local governments issued $87 billion of these bonds.

Advanced refunding bonds, which constituted 40 percent of long-term municipal bond issues in 2011, allow government entities to refinance their non-callable high interest debt and thus lower their overall borrowing costs. States won’t be able to reduce debt service costs by reissuing lower rate debt.

If Camp’s plan were enacted, bond-financed private projects would likely be shelved and because most states have caps on their total debt service, more public projects would be shelved as well.

Changes in taxable income. The Federation of Tax Administrators reports 36 states and the District of Columbia start with the federal definition of adjusted gross income (AGI) or taxable income to calculate state taxable income, generally referring to a specific line on the federal 1040 in their instructions. In Camp’s plan, changes to the sources of income and the repeal of many income adjustments, such as education deductions and moving expenses, increase AGI. The substantial increase in the standard deduction is offset by the repeal of many itemized deductions at the federal level but since more states have their own standard deductions and adopt the federal itemized deductions, taxable income will increase.

Reduction of the Earned Income Tax Credit. 24 states and the District of Columbia have a state EITC calculated as a percentage of the federal credit. Camp’s EITC would be less generous, lowering the value of the state credit, saving the states money but at the expense of low income families.

The net impact of Camp’s plan on state governments is far from clear.  By reducing federal subsidies, it will likely boost overall costs to state and local governments. But increasing taxable income will increase income tax revenue, offsetting some of those costs, at least for the income tax states.