One item would be a major provider of new revenue for the Federal Government, but it could also turn President Reagan's tax-reform plan into a tax increase for millions of upper-income Americans in high-tax states. The other would bring in only peanuts, relatively speaking, but it could radically change the life-styles of businessmen, professionals and their clients throughout the nation. Together, the proposals to eliminate the deductions of state and local taxes and to restrict severely those for business entertainment have emerged as two of the most controversial parts of the President's tax package. Both have already stirred passionate campaigns of opposition and seem likely to remain at the center of the tax debate. An examination of the two issues:
On the theory that income owed in taxes to state and local authorities should not be taxed again, Washington has traditionally allowed taxpayers to deduct those funds from their federal total. For those who itemize their deductions, especially if they live in a state with high taxes, the largest single write- off on their federal return is often the combined total of state and local taxes on income, real estate and retail sales. Residents of New York State who took the deduction in 1982, for example, saved an average of nearly $1,300 on their federal tax bill. Not coincidentally, the Empire State also imposes the nation's highest state and local tax rates.
Reagan opposes this arrangement on both philosophical and financial grounds. By allowing residents of high-tax states to lessen their federal obligation, he contends, Washington in effect underwrites big spending at the statehouse level, which he abhors. Moreover, since only one-third of U.S. tax returns are itemized, Reagan notes, the benefit is not even available to a majority of taxpayers. "But they are being forced to subsidize the high-tax policies of a handful of states," the President said in his speech Tuesday evening. "This is truly taxation without representation."
But more than principle is at stake. The $33 billion in new federal revenue that would be generated in fiscal 1987 by eliminating the deduction for state and local taxes could not easily be found elsewhere. One of Treasury Secretary James Baker's first decisions in his reshaping of the Treasury I tax-reform package was not to tamper with that provision, and it survived intact in Treasury II. If they give in now on sub-federal tax deductibility, Administration officials fear, they run the risk of losing the whole tax- reform plan.