The Congressional Budget Office has issued a report on the deductibility of state and local income taxes, looking at the benefits and drawbacks of the system.

"Deducting state and local taxes under the federal individual income tax subsidizes the revenue-raising activities of state and local governments as long as the revenues are raised through deductible taxes," said the report. "Because taxpayers who claim the 'taxes-paid' deduction may thereby reduce their federal tax liability, the 'cost' to the itemizing taxpayer of an additional dollar of revenue raised through deductible state or local taxes is less than a dollar. If that lower cost for taxpayers encourages state and local governments to raise revenue from deductible sources, the reduction in federal tax will constitute an indirect federal subsidy of eligible taxes at the state or local level."

The report looks at whether such a federal subsidy is an efficient use of "scarce federal resources."

"If the taxes-paid deduction encourages state and local governments to use deductible taxes to fund additional services that create spillover benefits to other regions of the country, then the deduction provides a benefit to the federal taxpayers who implicitly finance the preference," said the report. "If the deduction does not prompt states or localities to change their behavior in that way, or if they use deductible taxes in place of nondeductible levies and do not offer additional services, then the deduction provides a federal subsidy to taxpayers that is not related to state and local services but to the amount of individuals' income and whether or not they choose to itemize on their tax returns."

The report notes that lawmakers have at various times limited the deductibility of state and local income taxes, and as part of its analysis, the CBO presents various alternatives for limiting deductibility.

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