How Tax Reform Could Hurt Your City

Different provisions that could boost federal revenue could hurt state and local economies.

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There are few common points of agreement in Washington, but politicos of many stripes concur on one thing: The tax code is broken. There's plenty of talk on Capitol Hill and in the White House about broadening bases and lowering rates, but even if lawmakers take the big step of fixing the tax code, it could make for problems in city halls and governors' mansions across the nation.

That's because some proposed reforms could hurt state and local budgets and economies, even while they potentially improve federal revenues.

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"Although the federal government has no jurisdiction over tax rates in state and local government, it does set the rules that affect state and local governments' abilities to raise revenues," says Tracy Gordon, a fellow in economic studies at the Brookings Institution, a Washington-based think tank.

Comprehensive tax reform has long been elusive, but it now appears to finally be on the table for Washington as politicians seek to create broad fixes to the nation's deficit woes. President Obama has proposed keeping current tax rates in place for one year beyond their end-of-2012 expiration date for Americans earning $250,000 or less, opening the door for broader tax reform next year. Meanwhile, Republican Senate Minority Leader Mitch McConnell has have proposed an extension of current tax rates for a yearand instituting a "hard requirement" to accomplish comprehensive tax reform. . Montana Democratic Sen. Max Baucus has also promised a detailed tax reform plan.

The details of those reforms can be wonky, but the results could be simple and painful, say some experts, burdening state and local economies.

One proposal involves ending the federal deduction for state and local income taxes—a break that cuts annual federal revenues to the tune of $70 billion as it indirectly subsidizes state and local governments. Last year's Simpson-Bowles plan listed cutting or curbing the tax break as a possibility, and Mitt Romney has also said that ending the deduction is a possibility. Residents of high-tax states like New York and California would be hit hard by eliminating this deduction.

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Add to that the idea of capping or eliminating the deduction for interest on municipal bonds, which could make buying the bonds less attractive, making it tougher for cities to borrow money. In his FY 2013 budget, President Obama proposed capping this deduction for high earners.Another break that Gordon points to as crucial for local governments is the mortgage interest deduction. President Obama has proposed capping the deduction for wealthier Americans, and presumptive Republican nominee Mitt Romney has said he would eliminate it for high earners' second homes. The deduction was designed to promote homeownership, and it has also put millions of dollars in the pockets of Americans, particularly the middle and upper classes, though many economists question whether the deduction actually promotes homebuying. While lawmakers may be hesitant to altogether scrap this sacred cow of tax breaks, cities and states will certainly be watching any proposed tweaks closely.

"That mortgage deduction is very important," says Jim Diffley, senior director of U.S. regional services at economic analysis firm IHS Global Insight. He says that it's worth a sizable chunk of money, particularly for taxpayers in more expensive regions of the country, like the Northeast.

Michael Wallace, program director of community development at the National League of Cities, points out that most state and local governments are required by law to balance their budgets, unlike the federal government. If reforms are put into place that hurt state and local revenues, he says, cuts will be absolutely necessary.

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"The tax incentives really are incentives," says Wallace. "They tend to generate economic activity. You take those away, and there's nothing to replace them at the local level. So I think you just kickstart a downward spiral that is very hard to recover from."