Everyone hates paying taxes, but property taxes are a particular hot button with voters.
Now some in Congress are proposing to take some of the sting out of paying property taxes by making it easier to deduct them when filing federal income tax returns. This is a bad idea, for several reasons.
Currently, taxpayers must itemize deductions to subtract such local taxes from income subject to federal taxation. If these taxes (plus any mortgage interest, charitable contributions and other sundry allowable expenses) exceed the standard deduction, the taxpayer gains by itemizing. If the itemized deductions fall short of the standard deduction, it is better to claim the latter. That has been the deal for decades.
Impetus for change comes from the fact that fiscal doodoo flows downhill. Federal transfers to states have shrunk over time. In many states, transfers from state coffers to local units of government have similarly fallen. Local governments respond by raising real estate taxes, their primary source of local revenue. Homeowners naturally don’t like to pay more taxes. So they contact their elected representatives to ask for relief.
Increasing the deductibility of such taxes from federal taxation would effectively transfer more federal funds to homeowners, completing the circle. This would further complicate already overly complex tax returns and set a terrible precedent for other gimcrackery, not to mention further distort incentives in housing markets already suffering from excessive government micromanagement.
Many other nations do not allow deducting taxes paid to lower units of government. Hardly any other nations allow deduction of mortgage interest, as does the United States. Critics have long regarded the option on federal returns to deduct mortgage interest, but not rent, as an injustice.
The system has tradeoffs. Households with few allowable expenses effectively get a windfall by taking the standard deduction. High-income families with very high real-estate tax and mortgage-interest expenses can realize enormous tax reductions compared to what they would owe using the standard deduction.
So yes, the current system is arbitrary. But so would be any change. And in taxation, predictability and consistency over time are virtues. The tradeoff between itemizing and not is not perfect, but it is practicable. For years, people have planned accordingly. Altering that tradeoff now would confer a financial benefit on one subset of homeowners at the cost of less general tax revenue. In the long run, someone else will have to pay more.
But in an election year, the immediate benefit to the families who would benefit is much more visible than the longer-term cost to other taxpayers as a whole. With recession looming and many families facing other housing-related financial problems, the likelihood that Congress will sacrifice longer-term interests to election-year pandering is unfortunately high.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.