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How less can be more: using the federal income tax to stabilize state and local finance.

Government at all levels--fideral, state and local--are suffering through ever more severe budget crises. The interests of these different levels of government are often assumed to be in conflict. For instance, it seems reasonable to believe that if the federal government were to get its finances in order then that would mean less aid to the states. Yet this common assumption is not necessarily correct; what U. the federal government saved money through cutting subsidies that are likely doing more harm than good? Currently, the Internal Revenue Code is doling out more than one hundred billion dollars per year in Just such subsidies to the states. If these subsidies were cut completely, this alone would greatly aid resolving the disputes that are now regularly threatening to bring the federal government to a standstill. This Article advocates deep cuts, but not the complete elimination of these subsidies because much smaller subsidies could be better focused on enhancing state and local fiscal stability, and thus the federal government would be spending less while helping the states more. Most importantly, this Article advocates that the federal government encourage states to use the local property tax in contrast to more volatile revenue sources.

I. INTRODUCTION                                           415


  A. Diverse Perspectives on the Proper Role of the       421
  Federal Tax System

  B. Preliminary Objection                                424

  C. The Heart of the Maater: The Federal Interest in     426
     Ex-Ante StabilLation

  D. Connection to the Benefit Principle                  430


  A. SALT Itself Section 164(a)                           433

  B. Exception for Special Assessments: Section           434

  C. Exclusion for the Interest on State and Local        434
     Bonds: Section 103

  D. Above-the-Line Deduction for Real Property           435
     Taxes: Section 63(c)(1)(C)

  E. Build America Bonds: Section 54A.A                   437

  F. A Tangled History                                    438

  G. History and Salience: How to Proceed Prudently       443

IV. THE REFORM PROPOSAL                                   448

  A. Outline of Proposed Refbrms                          448

    1. Make the Property Tax Primus Inter Pares           448

    2. Better Manage the Federal Financing Subsidy        448

  B. Justifying the Reforms                               449

    1. Stability                                          450

    2. Efficiency                                         453

      a. Whither Jurisdictional Competition (the          455
         Tiebout Model)?

      b. Conclusion on Efficiency                         458

    3. Equity                                             458

      a. An Objection                                     461


  A. How Much Impact Can Federal Tax Policy Have?         466

Vi. CONCLUSION                                            468

The fiscal crisis that is now enveloping the United States federal government has been long foretold; so too the crises overwhelming the states. These overlapping--and seemingly perennial--crises have spurred many calls for reform, including of the tax systems at both the federal (2) and state (3) levels. A longstanding common, and reasonable, assumption has been that if the federal goverment saves money through cutting its subsidies to the states, this will heighten the crisis in the states. (4) In this article, I argue that this common fear is exaggerated because the tax subsidies I identify do more harm than good.

The reforms proposed in this article will save the federal government billions of dollars while also helping the states improve their revenue systems. These reforms require little institutional design and are consistent with our best theories of fiscal federalism. What specifically should be reformed? The federal income tax allows (some) taxpayers to deduct (some) of their state and local taxes; this is the State and Local Tax (SALT) deduction of section 164. Despite the parenthetical qualifications, this deduction is estimated to have cost the federal fisc almost $75 billion in 2009. (5) In addition, investors in state and local bonds have the interest they earn excluded from federal income tax, primarily under section 103, for an annual total cost to the federal government of at least $40 billion per year. (6)

Eliminating, these poorly-designed tax expenditures relating to state and local government (7) could therefore save over one hundred billion dollars per year or one trillion dollars over ten years. To put this potential savings in context, this summer the federal government struggled to find $2.4 trillion in savings over ten years. (8) It only found one trillion, and so Congress is spending the fall of 2011 desperately searching for another trillion or so in savings, which is about what could be saved merely by eliminating the pieces of the tax code discussed in this Artiele. (9) Furthermore, the stimulus plan of 2009 directed at least $223 billion to states and local governments. (10) If the 'focused use of the federal subsidy proposed here obviated the need for even a percentage of this federal intervention then this would be another significant savings.

Related reform proposals from both parties have been piecemeal, contradictory to one another, and generally ad hoc. Thus, both major deficit reduction commissions recommended cutting some of these tax expenditures last year, (11) as have many other commentators and policymakers over the preceding decades--including President Obama in the American Jobs Act of 2011. (12)

The leading academic treatments of the relationship between the federal and state revenue systems--and there have not been very many (13)--provide vital theoretical insights but only limited pragmatic guidance to federal tax policymakers. (14) This article begins with these insights and develops a relatively comprehensive analytic rubric that indicates specific cost-saving reforms.

There are three reasons that well-wrought federal tax reforms can save the federal government money while providing more help to the states. First, the current system of federal tax subsidies is so disjointed and ill-considered that even minor refinements could yield big savings. Second, state and local tax systems are often so poorly designed that there are many high-value/low-cost reforms that the federal government can nudge the states to make. Third, the particular reforms I am advocating, and especially the privileging of the local property tax, (15) are urgent as states and localities adopt short-term solutions to the current crisis that are likely to make the next one worse, with continued national implications. It is no surprise that property taxes are particularly unpopular in the midst of a real-estate-driven recession, (16) but this understandable political dynamic should not prevent the federal government from trying to rationalize the way that the federal system funds itself.

The history of the property tax leads to the specific observation animating the argument of this article. During most of the past century, and especially since the passage of Proposition 13 in California in 1978, states have turned excessively away from funding services at the local level with the property tax and have moved instead to using the state-level sales tax and the income tax. The federal government's role in this shift was minor. Though the federal government did not cause this decline, it can encourage its reversal through a (minor) restructuring of the SALT deduction so as to make more local property taxes deductible and other state and local taxes less deductible (or not deductible at all). (17)

The federal government should do this on the grounds of enhancing state fiscal stability, which will concomitantly also advance tax system efficiency and equity. (18) As to stability, the property tax base is the most stable tax base. (19) The federal government is (properly) a partner to states and localities on a wide range of programs, but the federal government has had to cope with these partners 'embarking on ever wilder revenue roller coasters. (20) Mitigating these revenue swings by ex ante encouraging a more stable tax system would be money well spent. The other state and local taxes, particularly income and sales taxes, are (1) not as politically endangered and (2) not as desirable from the perspective of the theory of tax assignment in a federal system. The federal government has no interest in encouraging the use of these taxes, and the SALT deduction should be reduced accordingly.

Yet we need to recognize that there is a danger in further encouraging the use of the property tax; state and local governments are already overusing the federal government's debt financing subsidy, including for financings secured by property tax revenues. There is no need to attempt to calculate whether it might nevertheless be worthwhile to encourage the use of the property tax because limiting the federal financing subsidy has long made sense as sound policy. Indeed, with the recent success of the Build America Bonds program (BABs), there is now a model as to how the federal financing subsidy can be wisely reformed so as to encourage better--and hence more stable--state and local borrowing. This reform would also result in savings because currently the subsidy is being disbursed too broadly.

As for improving economic efficiency, forcing taxpayers, particularly multi-state businesses, to compute taxes in multiple jurisdictions imposes an efficiency loss on the economy even if there is a countervailing gain from the tax competition. Yet the gain from competition need not be counterbalanced by such a great loss from transaction costs. There could be a number of prescribed tax bases and the different states and localities could then compete as to rates, but not the bases. (21) Though it would be ideal for there to be an entire range of such tax bases, and most especially a national value added tax (VAT) that the states can supplement, the property tax base is a reasonable place to start. After all, like the VAT, there is significant literature praising the relative economic efficiency of the property tax. To be sure, there are variations in property tax assessment methodology and there is no suggestion that this is going to be the only tax base used by states and localities, but the argument of this Article is that the property tax can expand to replace some of these inferior taxes to the general benefit of all. There is also little argument that the federal financing subsidy could be more efficiently deployed.

What of equity, the third axis of possible benefit? Surely both equity and efficiency cannot be advanced. This equity argument could rely on the proposition that the property tax is progressive, but, as discussed below, (22) that surmise does not appear to be justified. To foreshadow, there is not, nor will there be, a strong case that the property tax is either progressive or regressive when considered nationally. (23)

The heart of the equity argument of this article is based on the current instability of state revenues: this fiscal instability hurts the most vulnerable the most. (24) That is, it is the most vulnerable who are liable to have their benefits cut dramatically when unstable revenues plummet in sub-national jurisdictions and it is this group who cannot borrow to smooth spending. Of course, the seeming necessity of such cuts might be seen as an argument against hard budget constraints for sub-national governments, but, assuming such constraints, it seems reasonable to assume that the least fortunate will disproportionately benefit from a more stable tax base just as they now suffer disproportionately from an unstable one.

This article proceeds as follows. First, since I am proposing changes to the federal income tax in the name of fiscal federalism, in the next part, Part IL I start by explaining why it is appropriate to use the federal income tax to stabilize state and local finances. Part II also explains why previous approaches to the federal income tax as a tool of fiscal federalism have not yielded similarly concrete proposals. Additionally, Part II places the approach of this Article into a broader theoretical framework.

In Part III, the history of the tax provisions in question are briefly considered. It will be clear that none of the provisions were the subject of much analysis either before or after enactment; these provisions are proverbial low-hanging fruit for serious tax reform. In Part IV, in outline, the reform proposals are introduced. The reasons why these proposals would enhance the stability, efficiency, and equity of our federal system are then offered. With these theoretical advantages having been established, I return to the proposed reforms in Part V, where I elaborate upon them and explain why they should be effective. Part VI concludes.



A. Diverse Perspectives on the Proper Role of the Federal Tax System

The two tax expenditures in question are the State and Local Tax (SALT) deduction and the federal financing subsidy. Neither the exact terms of either tax expenditure, nor their interaction with each other, were products of careful thought and study. This under-theorization has been in part addressed by a series of important articles, especially as to the SALT deduction. These analyses will briefly be discussed to establish that, in their current forms, none is adequate to justify the deduction in its current form nor adequate to suggest pragmatic reforms.

The principle income tax analysis of the SALT deduction was done by Kaplow in 1996. (25) If the only concern is making the federal income tax a better income tax, then the question is whether it is appropriate to allow for the SALT deduction if individuals willingly pay state and local taxes in order to consume goods and services provided by these governments. If these taxes are for a consumption item, then they should not be deductible. Taxpayers cannot deduct the cost of private school tuition, so why allow a taxpayer to deduct a property tax that is fungible with tuition? One of the recent debt commission reports found just this argument convincing in its argument against the SALT deduction. (26) Yet it is uncertain which state and local taxes represent such consumption in theory, (270 and, in practice, the situation is even more muddled given what it is that taxpayers seem to understand about local taxes. (28) Reformers should be wary of changing the SALT deduction on a hypothesis about the relationship between state and local taxes and private consumption.

One might imagine a different justification for the SALT deduction. Stark has noted that the SALT deduction offers a mechanism by which the federal government could serve to equalize state resources. (29) Yet there are a number of problems with this proposal. First, it does not seem plausible politically; will richer American states really explicitly send revenues to poorer states? (30) Second, the terms of equalization are far from clear--if what is to be equalized is fiscal capacity, then how will that be decided? For example, not all public goods cost the same in all places. (31) If it costs more to build a school in a rural area, then will that area receive more than equal funds? And are only schools to be equalized', why not operas? Who decides? Finally (and relatedly), fiscal equalization threatens the hard budget constraints.(i.e., no bailouts from the central government) that are generally seen as essential to a properly operating federal system. (32) In other words, fiscal federalism relies on sub-national governments being responsible for their own destiny--if each sub-national government knew that, in the end, it would at least be equalized, then this encourages risky behavior. (33)

The SALT deduction can be given a macroeconomic function, and this is roughly the perspective that this Article adopts. Galle and Klick have argued that the SALT deduction (in conjunction with the Alternative Minimum Tax (AMT)) serves (clumsily) to automatically provide a subsidy to states and localities in the midst of an economic downturn because, as their incomes decline, fewer taxpayers pay the AMT and thus can take the SALT deduction.'4 If the goal of the SALT deduction is to enhance macroeconomic stability in this way, then this structure is a Rube Goldberg mechanism for doing so. How, within the realm of achievable reforms, might the SALT deduction contribute more directly to greater state and local fiscal stability?

Even on their own terms, all of these different analyses of the SALT deduction leave a great deal of room for additional theoretical analysis, but these various approaches are not consistent with one another even in outline. If, for instance, the SALT deduction is meant to equalize fiscal resources between states, then its current design, based on the situation of the individual taxpayer, makes little sense. If the deduction is meant to make the income tax a better measure of income on an individual level, then the deduction allowed for property taxes in particular--granted without regard to whether the property tax is a price voluntarily paid--is inappropriate.

Yet there are still deeper issues to be considered. First, the federal financing subsidy undermines truly competitive federalism because the central government is putting its thumb on the scale in favor of certain activities--specifically, borrowing. (35) Furthermore, this subsidy allows sub-national governments to avoid internalizing the full cost of their borrowing because the borrowing is subsidized by the national government, and so this subsidy is particularly suspect. (36)

A second big issue implicit in the discussion of the SALT deduction is the question as to how tax competition in a federal system is to be organized. Advocates of tax competition sometimes speak of it in unqualified terms--i.e., the more competition the better (37) --and yet the matter cannot be so simple. The rickety structure of Dormant Commerce Clause jurisprudence is, for instance, designed (in part) to prevent sub-national jurisdictions from competing in tax exporting--tax exporting is generally seen as "bad" tax competition. (38) Specifically, not all competition is created equal from the perspective of efficiency. Competition on tax rates (and public services) might be beneficial, but competition as to tax bases is probably not. (39) And it is not chimerical to imagine a federal system with relatively stable tax bases, but competition as to rates and expenditures. This is arguably a rough approximation of the German federal system, (40) and also of sales tax systems within states.

The difference between competition regarding rates and base leads to the question whether the SALT deduction should nudge states and localities towards competition as to a particular set of tax bases and, if so, which ones?

In sum, the perplexities involving the SALT deduction only deepen when one considers other key sections of the Code and theories of fiscal federalism more broadly. (41) To be sure, this Article cannot achieve a conclusive resolution of all these matters, but it takes a uniform approach to them that yields concrete policy proposals.

B. Preliminary Objection

The reforms this paper proposes would make the federal income tax a better tool in the context of fiscal federalism, but it would not make the federal income tax a better income tax. Specifically, the reforms will not help measure an individual taxpayer's ability to pay. The most obvious response to this worry is to note that the notion of a pure income tax is very hard to cash out (42) and, indeed., as outlined above, theoretical issues plague the attempt to get the federal income tax treatment of state and local taxes theoretically correct. Furthermore, given the state of the Code, it is rather late to be concerned about income tax purity.

Still, one might object to making the Code more confounding for reasons having nothing to do with income tax theory, which is what is proposed here. I would like to address this objection straightaway. I respond, with Weisbach and Nussim, that pursuing income tax purity at the expense of other public finance and social goals is procrustean. (43) There are certain policy objectives--perhaps administering certain kinds of credits--that are best administered through the income tax and not through a new federal bureaucracy. Achieving income tax purity at the expense of these other goals is like a homeowner using his leaf blower to blow all his leaves into a neighbor's yard. (44) Yes, the Code could possibly be pristine, but only at the cost of creating huge and relatively inefficient federal bureaucracies doling out the Earned Income Tax Credit, education credits, etc. So too here the Code will fail to contribute to other traditional goals of tax policy in a federal system through a quixotic search for purity. (45)

The specific policy argument as to the federal role in local government finance is as follows. As the federal government is traditionally--and properly--charged with the primary task of (re)distribution within the national economy, the federal government is also properly responsible for macroeconomic stabilization. (46) In the case of distribution-, the federal government could opt to -fill its role through the creation of large federal bureaucracies or it can try to leverage the information it already gathers through the income tax, and this, put roughly, is what the Earned Income Tax Credit and the various education credits achieve. (47) The federal income tax is similarly--and necessarily--already interacting with state and local tax and borrowing decisions, and so the Code is in a position to nudge states and localities to more stable tax systems ex ante, obviating in part the need for federal interventions ex post. (48)

C. The Heart of the Mailer: The Federal Interest in Ev-Ante Stabilization

Stabilization is the key reason for the federal interventions advocated here. State and local revenue systems have been showing greater and greater volatility, often greater than the underlying economy.49 In part this is because of the decline in use of the property tax and the increase in the use Of other taxes. (50) Both the sales and income taxes are more volatile than the property tax and both of these taxes are generally used by states in a manner that makes them more volatile still. The simple rule is: the narrower the base, the more volatile the tax, and the states apply income and sales taxes to a narrower than ideal base. A progressive income tax relies more on a small number of high-income taxpayers. A sales tax that only taxes transactions involving tangible property is more unstable than a sales tax that also includes services, especially because sales of tangible goods is a smaller, and shrinking, part of the economy. States have adopted income and sales taxes that are narrow in these ways. (51) Thus, states have not only moved to less stable tax bases in general (e.g., income v. property), but have made these taxes more unstable through their own design of these taxes. The federal government, as a stabilizer of last resort, should not be subsidizing these taxes in general, much less as currently designed.

It is also important to note the role of state and local debt. The use of debt at the state and local level has increased over the last decades. (52) Debt is often appropriate, especially for spreading the cost of capital projects across generations, but several aspects of this increase are particularly worrying.

To begin with, there is good reason to wonder whether it is appropriate for the central federal government to subsidize sub-national borrowing at all. Prima facie this subsidy undermines the hard budget constraints so important to fiscal federalism. If the subsidy is consistent with the theory of fiscal federalism, then it is through creating (or mitigating) positive (or negative) inter-jurisdictional externalities. (53) Yet the subsidy is not limited to the financing of such regional projects. Furthermore, it has long been understood that, as designed, the federal financing subsidy is "leaky" because it provides more subsidy to higher income taxpayers than local governments receive. (54)

Then there are specific worries. Though the amount of state and local debt has not increased in gross terms in the last decade, the amount of debt owed by states versus localities has continued to increase. (55) This suggests that, as in other areas, states have continued to expand their role relative to localities, even as state-level financing has become more unstable. This has had two implications. First, state budgets have become more constrained because greater parts of the budget are dedicated to debt service. (56) Second, states are using general tax dollars for projects that can finance themselves. (57)

Finally, states have allowed their localities to use speculative land-secured financing techniques in ways that contributed to the over-heating of the housing market and, amidst the crash, these financings have further undermined state and local tax bases. (58)

Again, it is the federal government that has historically stepped in to provide macroeconomic stimulus in times of economic crisis, (59) a task made more difficult by the procyclical movements of state and local revenues and the misuse of state and local debt. This role for the federal government has long been seen as theoretically appropriate; for instance, it is only the federal government that can provide a large fiscal stimulus knowing that most of the stimulus will not escape the jurisdiction. (60) And, the law follows theory here to a considerable degree given that, in general, it is the federal government, and not state or localities, that can borrow in times of crisis. (61) Yet given its current fiscal situation, the federal government is likely to be less, not more, able to step in and counteract state procyclical spending cuts during downturns. (62)

Even if the federal government were to eschew this stabilizing role, however, it is still bound to state fiscal fortunes by numerous joint federal-state programs related to the federal government's redistributive role, such as Medicaid. Though the specific desigi of many of these programs may be questionable, the theoretical idea that there is a joint state-federal interest in the health care of the indigent seems unassailable to this observer. It is canonical to theories of fiscal federalism that it is the central government that ought to look after the weakest in society.

It could be objected that the entirety of these federal interventions obstruct the operation of beneficial competition between states and localities. Yet, as noted above, sophisticated advocates of fiscal federalism do not advocate just any kind of competition. Competition between states predicated, for instance, on tax bases versus rates, is probably not, on balance, beneficial. The proposals herein would channel tax competition to the kind of competition recommended by our best theories of tax assignment.

There are also limits to the analogy between public and private markets that undergirds the competition argument. (63) States cannot go bankrupt and localities rarely do, and so the market for jurisdictions is not the same as the private market where painful bankruptcy and ultimately liquidation are more realistic options. This disanalogy has to do with the current state of the law, (64) and the law is unlikely to change as a matter of fact, but the law is not just an accident, but is based on the nature of public versus private entities. (65) No one would want all the public schools in a particular district to be liquidated nor all police service in a particular town to be discontinued. This has to do with the public nature of the goods these entities generally provide (e.g., neighboring communities will suffer if a bankrupt town is engulfed by crime or flames), but also with the political nature of these entities and the value we attribute to them even amidst financial distress. Should the political community formed with neighbors over decades be dissolved because the current city manager made poor business decisions? And thus it is reasonable that the law governing municipal bankruptcy is not the same as the law governing the bankruptcy of private entities--and it will not become the same.

Because sub-national entities are not going to be subject to the full consequences of poor financial decision-making ex post, it is particularly important that the federal government nudge these other entities to better policies ex ante. To be sure, at some point such nudging will go too far and undermine the rationale for fiscal federalism, but the reforms proposed here, reforms to already existing programs, do not seem to come close to approaching that level. It is also the case, of course, that the federal government cannot necessarily afford every possible clever nudge. Hence we must remember that the reforms under consideration could--and should--result in net savings to the federal government.

D. Connection to the Benefit Principle

From the federal perspective of encouraging stabilization, the federal government should take the position that the benefit principle of taxation should be used to the extent possible. The benefit principle states: the government should levy taxes on citizens in proportion to the benefits that citizens demand from the government. (67) The benefit principle enhances stability both by limiting spending (i.e., voters only get what they want) and making it easier to raise revenue (i.e., voters know where their money is going). Given that governments cannot apply the benefit principle perfectly, (68) the practical manifestation of the benefit principle in taxation is through imposing levies on specific taxpayers for specific goods or services to the extent possible. (69) Applied to the theory of tax assignment in a federal system, the benefit principle indicates that taxes should be assigned to the lowest level of government consistent with the provision of the good's or services that the taxes are to be spent on. (70) Thus, taxes to support schools are generally assigned to the local level so that taxpayers can observe the connection between their taxes and their schools and can then vote for the level of provision that they want. For national defense, such assignment is not possible, and it is properly the role of the central government. In some circumstances, the property tax acts as a benefit tax71 and in any properly designed special assessment the assessment even more approximates a benefit tax. Hence, this paper will argue that both property taxes and special assessments should be favored by the federal income tax. State sales taxes and income taxes have the least benefit-type characteristics, which is why they are typically not assigned to local governments to raise revenue and should not be encouraged by the national governrnent. (72)

Reforming the federal financing subsidy is also consistent with the benefit principle because my proposed reforms would require a tighter connection between the (national) costs of the subsidy and (national) benefits. Specifically, the proposal is that the federal financing subsidy should only be used for projects of regional significance. If the subsidy is not being used in connection with inter-jurisdictional externalities, then the federal goverment is either subsidizing projects that do not need help or encouraging the pursuit of infra-marginal projects. If the latter, then the federal government is encouraging borrowing that undermines state and local stability because, by definition, the money spent on this borrowing would be better spent elsewhere (or not at all).

Given the connection between the benefit principle and stabilization, one might assume that the benefit principle provides a big part of the analytical framework for the federal government's stabilization function. Indeed this is so, and some role for the benefit principle is not controversial (73) and brings together the political right (74) and the left. Thus even commentators perceived as more concerned with the ability to pay principle, such as Murphy and Nagel, see the place of benefit taxes, though they are careful to explain that benefit taxes are appropriate only in the context of an already generally just distribution of resources. (75) This can be given a federalism gloss by saying that benefit taxes at the local level are justified if the central government is making sure there is a generally just distribution of resources.

Nevertheless, the benefit principle does not exhaust the federal imperative to stabilize for a variety of reasons. First, not all benefit-type levies need the same level of federal support. User fees, such as for waste pickup or water, hew even more directly to the benefit principle because they are more of a direct fee for a service and thus, when applied properly, are most efficient of all at giving taxpayers what they want at the price they want. (76) Yet I do not think that the SALT deduction should allow a deduction for user fees, but do think that it should allow for a deduction for property taxes and special assessments (and, ideally, exclusively so). The reason for this choice is that there does not appear to be a national tax assignment problem affecting the utilization of user fees (77) and therefore the federal government should not change the rule that such fees are not deductible because they are for private consumption. This is not to say that there is no federal interest in proper utilization of user fees. To the contrary, there is and that interest can be vindicated through the federal financing subsidy; there is no reason to subsidize user fees twice. The use of property taxes and assessments has declined over the last hundred years, and these are what the federal government should encourage.

The main reason that the benefit principle cannot be wholly relied upon is that its connection with the property tax is equivocal, and so it would be perilous to say that the federal government should advocate for the property tax because it is a benefit tax. Even if it is not a benefit tax, the property tax has desirable characteristics for other reasons: for instance, it is a relatively stable tax because of how it is collected and it is efficient because of its uniformity. Those reasons are addressed in depth in Part IV infra. For now, the primary point is that the stabilization justification for the property tax is related to, but ultimately broader, than the benefit principle.

There is one final related objection to be considered. After all, allowing for either a deduction or an exemption reduces the cost of benefit taxation at the local level; why should the federal government essentially give a discount on (certain) local serviees? (78) The familiar answer from within the benefit principle is that the central government is properly concerned with inter-jurisdictional externalities, positive or negative. This answer is most satisfying as applied as to the tax exemption for state and local government borrowing, which exemption, ideally, would only be available to subsidize projects that generate positive externalities/or mitigate negative ones relative to the financing jurisdiction.

But what of subsidizing the property tax through deductibility? There is no proposal being made that only property taxes that create positive inter-jurisdictional externalities be deductible. Yet my argument can and should be understood in terms of inter-jurisdictional externalities. The instability of sub-national tax systems is undermining the national economy, so too the transaction costs of multiple inconsistent sub-national tax bases and the dramatically inequitable spending cuts that fiscal volatility results in. Currently, the relatively uniform and stable property tax base is being underused and the federal SALT subsidy diffused aimlessly, but at great expense. What I am arguing is that the federal government should focus its subsidy on the suboptimal use of the property tax in order to better play its stabilization role. The decline of the property tax is a national tax assignment externality.


A key claim of this Article is that the federal government is in a position to do more with less by tweaking the interaction between the federal and state tax systems. It could be objected that this is prima facie implausible, but a brief review of the history of the key provisions under discussion demonstrates that they represent a series of ad hoc decisions and can easily be unified and improved. (79)

A. SALT Itself Section 164(a)

The deduction for state and local taxes was already in the original version of the Code. (80) This deduction was not a product of extensive discussion, though over the decades there have been some discussions of section 164, most notably in the mid-1980s in the discussion preceding the Tax Reform Act of 1986. The Reagan Administration initially proposed repealing the deduction altogether, a proposal that attracted an enormous amount of criticism. (81) The final reform eliminated the deduction for sales taxes; this deduction too has crept back into the Code. (82)

B. Exception for Special Assessments: Section 164(c)(1)

Section 164(c)(1) denies the SALT deduction for "taxes assessed against local benefits of a kind tending to increase the value of the property assessed," though this section does allow the deduction for interest expenses. One assumes, and the main report confirms, (83) that this provision is not followed by many. That is, taxpayers just deduct all the items on their property tax bill, whether or not they are nondeductible assessments.

The predecessor to current section 164(c)(1) was in the original Code of 1913; (84) there has been little discussion of it then or since. In essence this section means that so far as a state or local charge is tightly tied to a benefit, then it is no more deductible than any other expenditure for private consumption. (85) Though untheorized (based on current research), section 164(c)(1) is consistent with the view that the SALT deduction only aims to provide deductions for state and local taxes that do not serve as prices for essentially private consumption.

C. Exclusion for the Interest oil Slate and Local Bonds: Section 103

Section 103, the exclusion from taxation for interest on state and local bonds, also dates to the original Code. It also received little discussion, though this is understandable since whether the federal government could legally tax this interest was not made clear until 1988. (86) In addition, it was seen as politically inadvisable to tax interest on state bonds. This seemed to have been an issue in connection with the passage of the Sixteenth Amendment--proponents of the income tax insisted that the new tax would not tax "the instrumentalities of a State or a subdivision thereof." (87) In 2011, there is no question that the federal government can repeal section 103 or attach other conditions to the use of the tax exemption. (88)

As noted briefly above, there are numerous policy objections to section 103. (89) For instance, as an exclusion from income tax, the benefit derived from section 103 is worth more the higher a taxpayer's marginal rate (as with the SALT deduction). Also, a government entity only gets the benefit of the exclusion to the extent it borrows, which is a perverse incentive if we are looking to enhance stability. There is also little reason for the federal government to subsidize just any state or local project; the federal government should only subsidize projects that generate positive externalities or mitigate negative ones relative to the financing jurisdiction. (90) None of these (or other) concerns had much effect on section 103, until recently. (91)

D. Above-the-Line Deduction for Real Property Taxes: Section 63(c)(1)(C)

In 2008, Congress approved a two-year, above-the-line deduction specifically for property tax payments. The provision allowed a deduction for the lesser of "the amount allowable as a deduction under this chapter for State and local taxes described in section 164(a)(1) [the tax on real property], or $500 ($1,000 in the case of a joint return)." An above-the-line deduction is a deduction that all individual taxpayers can take, regardless of their other deductions. Formally, these are the deductions listed in section 62. Theoretically, these are the deductions that are allowed because they (usually) reflect the cost of earning income and so should be included in the measurement of income in the first instance. (92) Other deductions, the so-called itemized deductions indicated in section 63(d), are only, pragmatically, available to taxpayers that do not take the standard deduction of section 63(c). About two-thirds of taxpayers take the standard deduction. (93)

To use an example: assume that the standard deduction is $5000 and that taxpayer Y has paid $4000 in property taxes that would be deductible under the SALT deduction. Yet the SALT deduction is an itemized deduction and so Y should choose the standard deduction and is not helped by the SALT deduction; she deducts $5000. One can readily see why, in. general, only wealthier taxpayers, i.e. those taxpayers with higher state and local tax liability and other possible itemized deductions (such as for charitable giving), actually take advantage of the SALT deduction. (94)

Therefore, by allowing a certain portion of Is property tax liability to be deducted above the line, say $500 worth, Congress has allowed Y to enjoy the benefit of the SALT deduction and the standard deduction, for a total deduction of $5500 rather than $5000.

The specific reasoning for this temporary reform was sparse; for instance, here is the House Committee on Ways and Means:
  The Committee believes an additional standard deduction
  for real property taxes is appropriate in order to help
  lessen the impact of rising State and local property tax
  bills on those individual taxpayers with insufficient
  total itemized deductions to elect not to take the
  standard deduction."

So far as this observer knows, there was no increase in property tax bills at this time--unless the Committee meant that, because of falling house prices, property taxes were increasing as a percentage of a house's then-current market price because the assessments of local assessors were lagging the market. If this is so, then this change might have had some small impact on influencing taxpayers to stay in their homes, especially if they were not itemizers.

E. Build America Bonds: Section 54AA

As a response to the Great Recession, Congress made Build America Bonds (BABs) available to state and local governments in addition to the exclusion available under section 103. (96) BABs are a kind of tax-credit bond. The most popular form of BAB worked (roughly) like this: (97) A local government or state issues bonds for a project on the taxable market. The federal government then writes the governmental issuer a check for a certain percentage of the interest owed, thirty-five percent under the original program. Because the subsidy is paid directly to government issuers, this subsidy is more efficient than the traditional section 103 subsidy. Furthermore, because BABs were taxable they were expected to allow state and local governments to reach more customers, even in an unsettled market.

The original BAB program, which expired at the end of 2010, was generally deemed to be a success. As the Obama adminislration explained:
  From April 2009 through December 2010, more than $181 billion
  in Build America Bonds were issued in over 2,275 transactions
  ... During 2009-2010, Build America Bonds gained a market
  share of over 25 percent of the total dollar supply of State
  and local 98 governmental debt. (98)

Consistent with this success, the administration has proposed reviving and expanding the BAB program. In particular, the administration would allow BABs to be used for a wider variety of projects. (99) The administration would lower the reimbursement rate from 35% to 28%, reasoning that "[t]he 35-percent Federal subsidy rate for the original Build America Bond program represented a deeper Federal borrowing subsidy for temporary stimulus [and that currently] it is appropriate to develop a revenue neutral Federal subsidy rate relative to the Federal tax expenditure on tax-exempt bonds." (100) Note that in expanding this program the Administration has not proposed any additional regulation of the tax-exempt market (indeed the Administration's proposal would loosen the limits on the use of BABs and traditional section 103 financings).

F. A Tangled History

The initial federal income tax only applied to a small number of high-income taxpayers. (101) Thus the first big shift to consider is that the SALT deduction is now a feature of a "mass tax." (102) Additionally, because of the advent of the standard deduction, the Alternative Minimum Tax (AMT) and section 68, (103) the SALT deduction is in effect claimed only by a hard to justify slice of taxpayers defined by their income, property ownership and geographical location (i.e., their local tax rates). This slice is hard to justify because not only is it relatively higher-income taxpayers that get to deduct at all, but not all such taxpayers because of the operation of the AMT and section 68 (when in effect), and only to the extent that a state has high enough taxes of the correct sort (e.g., income versus sales). (104)

At the time of the SALT deduction's inception, the primary state and local tax was the property tax. As the applicability of the SALT deduction has broadened in terms of taxpayers, so too has the kind of taxes to which it applied as the states and localities diversified their tax bases. Taxpayers have generally been able to deduct state and local income taxes and for large periods have been able to deduct sales taxes as well. Yet it should also be observed that, as marginal tax rates have fallen since the 1980s, so has the value of this deduction, (105) and this indicates that this is a smaller benefit that is now dispersed more broadly, though arbitrarily, and not, in effect, to two-thirds of taxpayers.

Yet the key part of the story that I would like to emphasize is the decline of the property tax. This is not controversial and can be measured in various ways. (106) For instance, property taxes represented 73% of all local government revenue in 1902, but 40% in 1992. (107) Even more strikingly, property taxes were 68% of combined state and local revenues in 1902, but 18% in 1992. (108) In other words, the decline in the role of the property tax has been extremely dramatic when one considers revenues at the state and local level, but it has also declined significantly looking at the local level alone. Thus, between 1977 and 1997, the percentage of the property tax as a percentage of own-source municipal revenues declined in forty-nine of fifty states. from a total of 42.7% to 28.8%.(109) The decline also occurred when one views the property tax relative to individual income, as the property tax represented 7% of personal income in 1930, but less than 3% in 2007. (110)

Less well known is that the use of assessment-type financing--the presumed concern of section 164(c)(1)--was also much more prevalent in 1913 (and long before). (111) This means, at least as to the small number of taxpayers initially paying the federal income tax, the assessments that would have fallen under 164(c)(1) were significant. (112) These assessments would not have been deductible, but the general property tax would have been. As with the general property tax, the use of assessment financing in the US also declined in the twentieth century, but the major turn was earlier, during the Great Depression. (113)

The initial structure of section 164 thus seemed to accord well (if accidentally) with traditional income tax principles. Taxpayers could not deduct assessments that seemed most likely to resemble private consumption, and these were often a significant amount of money. However, the general property tax, somewhat less likely to be connected to a specific benefit, could be deducted. Remember that the income tax only applied to the wealthiest taxpayers and it seems plausible to surmise that these taxpayers were the ones least likely to benefit from their higher property taxes in proportion to their cost, especially in an era when benefit assessments were much more common. Given that currently the volume of local assessments has declined considerably and the SALT deduction is available more broadly, this distinction is far less apt.

At the time of the initial granting of the section 103 tax exclusion, the subsidy given to state and local governments was less substantial because, again, the income tax was levied at a lower rate on a much smaller number of individuals. The import of the exemption has since exploded, along with its use. (114) Again, the exemption did not emerge originally so much from a policy calculation, as from a political and legal one.

In the 1960s, Congress became concerned that the tax exemption was in part being used to spur private endeavors that did not need a subsidy and perhaps were not even viable without one. At least some of the subsidy was also being used simply to generate positive arbitrage for state and local governments that were borrowing on the tax-exempt market and investing in the taxable market. (115) It should be noted that, with each additional bond issued, the cost of this exemption to the federal government increased, while the benefit to the local entity decreased. This inverse relationship between the cost and benefit of the subsidy is caused (in part) by the fact that the more tax-exempt bonds are issued, the lower the marginal tax bracket of the marginal tax-exempt bond buyer and so the greater the gap between how much money the federal government loses in the tax exemption relative to how much localities gain. (116)

Congress acted on the arbitrage concerns first in 1969; the primary rules, as we now know them, were passed as part of the Tax Reform Act in 1986. (117) Congress acted first on the issue of private activity in 1968, with rules governing "industrial development bonds;" these rules also take their current form from the 1986 Act and the new term of art is that a bond to fund a private enterprise is a "private activity bond" (PAB) and it is more difficult for PABs to get the tax exemption. (118) These changes have limited the issuance of tax-exempt bonds for the purpose of earning arbitrage and for subsidizing purely private businesses, but these practices have certainly not been eliminated, as the example below illustrates. (119) Yet what this example illustrates most crucially is that Congress has not significantly limited the ability of state and local governments to trigger the federal financing subsidy to regional projects that should be of concern to the federal government.

A mortifying symmetry has now long existed between the under-enforcement of section 164(c)(1) and the leniency of the PAB regulations. What was supposed to happen--according to this observer--was that a taxpayer could not deduct her principal expense for special benefit assessments, just as a developer could not use tax-exempt financing to build infrastructure for private developments. Yet because taxpayers ignore section 164(c)(1) and the Treasury has issued overly generous PAB regulations, (120) developers are able to use tax-exempt assessment financing to build the infrastructure for private developments, and the new residents then deduct these assessments in total. Such use of speculative land-secured finance is widespread and has played a minor supporting role in the ongoing housing-driven economic cnsis. Marrying the SALT deduction to the section (103) tax exemption means that the federal government gave a double subsidy to many of the least advisable development projects.

In sum, for a good part of the twentieth century, the federal income tax indifferently subsidized state and local taxes even as it was indiscriminately subsidizing state and local borrowing. The term "indifferent" is meant to emphasize the point made above that the federal government did not accord any special solicitude to subsidizing the property tax, even as the use of the property tax was declining.

The "indiscriminate" use of the state and local financing subsidy primarily points to the fact that this subsidy was not directed to projects that should be of import to the national government. Yet the poor design of the subsidy was also was-a missed opportunity to emphasize proper use of the property tax. Suppose, for instance, that the federal government had declared that it would only extend the tax exemption to state and local projects financed through property taxes levied in developed areas. It is not being suggested that such a policy would have been advisable (on its own). (122) Nevertheless, by specifying that the tax exemption would be tied to the property tax, the federal government would presumably have given as big a bump to property taxes (if not bigger) than if it had limited the SALT deduction to property taxes. Adding the requirement that the exemption be used in "developed areas" to this possible reform is an attempt to prevent states and localities from utilizing the tax exemption for speculative projects. Again, this simple change is not being advocated without more, just noting that by making the tax exemption available to all kinds of projects and all kinds of financings--and all at the discretion of state and local governments--the federal income tax made it easier for states and localities to shift away from traditional property taxes and to borrow suboptimally.

G. History and Salience: How to Proceed Prudently

At the beginning of the Nicomachean Ethics, Aristotle instructs that "we shall be satisfied to indicate the truth roughly and in outline ... the educated person seeks exactness in each area to the extent that the nature of the subject allows." (123) This is the rough approach appropriate to policy decisions as to what federal tax policy should be relative to the local property tax. (124)

There are many reasons for accepting that policy arguments can only be approximations in deciding what federal policy should be as to state and local revenue systems. Starting at the level of theory, as discussed in Part IV.B.2.a infra, the incidence of the property tax is far from clear. Because this is so, even if there were a fine-grained theory of distributive justice so it was certain what the incidence of the entire federal-state-local tax system should be, (125) it would be difficult to determine exactly what role the property tax should play in such a system because its incidence is unknown. Further, there are variations across the country in the factors that influence incidence and also in citizen preferences not just as to the property tax, but as to the state-local tax system in general. (126)

Moreover, though it is indisputable that the use of the property tax has declined, it is also indisputable that this was for some good reasons, including revenue diversification, (127) and so it does not make sense to argue for a return to a historical average, assuming we could agree on how to calculate that average. As a matter of economic history, the shift from the property tax was occasioned in part because less and less wealth was property-based (at least in the sense of real property). Further, the property tax base has shifted to more and more residential property, as the economy has shifted away from manufacturing (done in expensive industrial plants). This suggests that part of the decline in the relative import of the property tax can be connected to the increased pressure on one part of the property tax base (residential). (128) Accordingly, the property tax revolts of the 1970s, like the property tax revolts of the 1930s, were connected to an increase in property taxes relative to the income of individual residential taxpayers. (129)

Yet this increase in the burden of the property tax was also caused by a host of contingencies. There was the high inflation of the 1970s (130) and official inaction as to rising property taxes (particularly in California), (131) coupled with the adoption of more stringent property assessment methods that made high inflation in property values particularly painful. (132) There were specific California contingencies that contributed to Proposition 13, the first shot of the modern property tax revolt, particularly the demand of the California Supreme Court that California equalize the funding of its public schools. (133) Finally. Proposition 13's advent itself encouraged the adoption of dramatic property tax limitation measures in other states. (134)

Currently, the property tax is similarly under attack--most notably by the continuing dramatic drop in real estate value and, especially in certain areas of the country, the aging of the population. (135) The connection between drops in real estate value and the unpopularity of the property tax should be clear; the connection with an aging population is that older taxpayers tend to be more liquidity constrained, thereby making the property tax a relatively greater burden.

This liquidity issue touches on another aspect of historical contingency. The property tax is collected in a way that appears to maximize its political salience (136) and, relatedly, its =popularity. Specifically, the property tax is generally collected once or twice a year in lump-sum payments. (137) State and/or local governments could institute property tax withholding, but have not. The private sector, through tax escrow, provides taxpayers with essentially this service. Tax escrow means that a mortgage servicer is charging a portion of one's property tax liability monthly along with one's monthly mortgage payments. Many mortgagees pay their mortgages automatically.

It could be objected that it is the property tax that is appropriately politically salient as is and that it is the federal income tax, because of withholding, that is not salient enough. (138) However, determining the appropriate baseline for political salience is a vexed and ultimately intractable as a matter of tax policy. One large reason is that the benefits of government spending are not obviously more or less salient than taxation to voters, and so how do we know what the voters want as to taxing and spending? (139)

As for local property taxes, it can be responded that they in particular need to be visible, just like the benefits they provide are visible, such as one's local public schoo1. (140) Thus, even if political salience is indeterminable at the national level, there should be a presumption at the local level that more salience is desirable. One might counter that the data suggests that voters hate the property tax even as they seem to like what it is being spent on and how (i.e., they like local governments--relatively), suggesting that the property tax is excessively despised because excessively salient, (141) and it certainly seems to this observer that many local public goods are not particularly salient relative to local property taxes (e.g., traffic control, clean water).

This debate can indefinitely continue and is only relevant here to the extent it relates to whether the property tax has shriveled to the extent that it merits federal attention, and to that I think the answer is yes. Here are the analytic touchstones. First, as repeatedly emphasized, state and local finance systems have become so volatile that states and localities are having their role in the federal system undermined. Second, and more specifically, the property tax has attracted so much animosity that its ability to function as a benefit tax has been undermined.

To see this second point requires going through a number of steps. First, it indeed makes sense to claim that the property tax must be relatively visible in order to operate as a benefit tax--that is, the voters opt for more or less property tax based on their preferences for local public goods. However, even proponents of the property tax as benefit tax concede that the tax revolts of the last decades have gone so far that in many cases the property tax cannot act as a benefit tax. 1 42 In particular, strict properly tax limitation regimes prevent local voters from modulating the property tax as they would like. Thus, whatever the plausible abstract arguments that the local property tax should be visible relative to the federal income tax, the current state of the tax indicates that there has been excessive turning away from the tax.

In conclusion, there is not a theoretical baseline for the property tax, and we cannot look to history for clear guidance. The decline in the property tax was (and is) related to major shifts in the economy and society; it would be foolish for the federal government to set itself against such trends. However, the historically and psychologically contingent aspects of this shift should be of concern to the federal government, especially to the extent that the decline in the property tax is tied to increased state and local fiscal volatility. It is against this backdrop that the arguments and proposals herein should be measured. The argument of this paper can be recast as follows: The decline of the property tax base is partially a result of contingent factors that have caused the property tax base to decline more than optimally. (143) A change in federal tax policy could change the local property tax price slightly, thereby encouraging use of the local property tax. The story as to state and local use of debt is the minor-image; by some hard-to-quantify amount states and localities are now overusing debt and federal policy should work to encourage prudence. With this pragmatic framing in place, we are ready to develop the arguments in favor of encouraging the use of the local property tax and cabining the use of the federal financing subsidy.


(2.) See, e.g., THE NAT'L COMM'N ON FISCAL RESPONSIBILITY AND REFORM, THE MOMENT OF TRUTH 28 (2010) [hereinafter NAT'L COMM'N], available at pdf

(3.) See. e.g., CAL. COMM'N ON THE 21ST CENTURY ECONOMY, FINAL REPORT (2009), available at

(4.) See, e.g., JEFFREY H. BIRNBAUM & ALAN S. MURRAY, SHOWDOWN AT GUCCI GULCH 113-14 (1987) (account of successful argument made in the 1980s by states against cutting federal tax subsidies); Billy Hamilton, A Trillion Here and a Trillion There: States Face the Federal Budget Knife, 62 ST. TAX NOTES 115 (Oct. 10, 2011); Adam Nagourney & Michael Cooper, Wary State and Local Lawmakers Try to Gauge Impact of Deficit Deal, N.Y. TIMES, Aug. 2, 201 1, at A15.


(6.) CONG. BUDGET OFFICE, THE DEDUCTIBILITY OF STATE AND LOCAL TAX.ES 4 (2008) [hereinafter CB01 (aggregating bond programs); JCT, supra note 5, at 46 (53 billion annual estimate for two years of Build America Bonds program). All of these numbers are the product of numerous contestable assumptions; this Article will rely on them nonetheless as the best estimates that we have because (1) this Article is not the place to engage in the lengthy debate as to how to calculate these counterfactual figures and (2) as to the figures at issue in this Article, the figures strike the author as reasonable,

(7.) "Tax expenditures" are defined by statute as "revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability." Congressional Budget and Impoundment Control Act of 1974, 2 U.S.C. [section] 622.

(8.) Carl Hulse & Helene Cooper, Leaders Agree on Outlines of Deal to End Debt Crisis, N.Y. TIMES, Aug. 1,2011, at Al.

(9.) Id. Note that I am identifying cuts that make sense from a long-term perspective. Given the state of economy in the fall of 2011, entirely cutting these tax expenditures immediately is probably not advisable.

(10.) See Robert P. Inman, State Fiscal Distress, 6 FED. REs. BANK OF ST. Louis: REGIONAL ECON. DEV. 65, 75 (2010). Note that Inman does not maintain that the stimulus plan was well designed and concludes that "a better strategy would be to build on the optimal structure of state government finances in normal times." Id. at 78. Inman does not elaborate on what this structure should be or how the federal government might do this; this Article is an attempt to do so.

(11.) See NAT'L COMM'N. supra note 2, at 31 (proposing elimination of tax exemption for state and local bonds); THE DEBT REDUCTION TASK FORCE, BIPARTISAN POLICY CENTER, RESTORING AMERICA'S FUTURE 34 (2010) (proposing eliminating the State and Local Tax (SALT) deduction, noting that this proposal to eliminate the deduction first rose to prominence under the Reagan administration in 1985).

(12.) American Jobs Act of 2011, S. 1549, 112th Cong. [section]401 (2011) (limiting the SALT deduction and the section 103 exclusion), available at DIT'T OF THE TREASURY, GENERAL EXPLANATIONS OF THE ADMINISTRATION'S FISCAL YEAR 2012 REVENUE PROPOSALS 20-21 (proposal for adding tax credit bonds, including a proposal that would limit SALT deduction); Bipartisan Tax Fairness and Simplification Act of 2011, S. 727, 112th Cong. [section][section] 106, 111 (2011) (would eliminate tax exclusion for interest on state and local bonds and replace exclusion with a non-refundable tax credit, but would not create new limit on SALT deduction); Tax Equity and Middle Class Fairness Act of 2011, H.R. 2495, 112th Cong. [section][section] 401, 523-24 (2011) (would in effect limit SALT deduction, while also replacing section 103 exclusion with tax credit bonds).

(13.) Cf Brian D. Calle & Jonathan Klick, Recessions and the Social Safety Net: The Alternative Minimum Tax as a Countercyclical Fiscal Stabilizer, 63 STAN. L. REV. 187, 18990 (2010) (describing the "legal literature exploring stabilization policy at the state level" as "minute" and design of an appropriate federal tax policy as an issue that has been "neglect[ed]"); see also Kirk Stark, The Federal Role in State Tax Reform, 30 VA. TAX REV. 407 (2010) (first article providing key framework). Though both of these related papers. begin to address the neglect, neither approach covers the same issues (e.g., neither discuss the section 103 exclusion) nor arrives .at a similar set of proposed "easy" reforms (e.g., reinstating an above the line deduction for only local property taxes). Very recently, Stark and Galle wrote an important piece specifically exploring how the federal government can work with states to better use rainy day funds in order to enhance state fiscal stability. Brian D. Galle & Kirk J. Stark, Beyond Bailouts: Federal Supports for State Rainy Day Funds, 87 IND. L.J. (forthcoming 2012), available at

(14.) See, e.g., David A. Super, Rethinking Fiscal Federalism, 118 HARV. L. REV. 2544 (2005); Louis Kaplow, Fiscal Federalism and the Deductibility of State and Local Taxes under the Federal Income Tax, 82 VA. L. REv. 413 (1996); Daniel Shaviro, An Economic And Political Look At Federalism In Taxation, 90 MICH L. REV. 895 (1992); Clayton P. Gillette, Fiscal Federalism and the Use of Municipal Bond Proceeds, 58 N.Y.U. L. Rev. 1030 (1983). See discussion of previous treatments infra Part II.A.

(15.) By "property tax" I refer to the tax on real .property, which is the vast majority of the property tax that is collected.

(16.) Frank Shafroth, Double Trouble for Property Taxes, 60 ST. TAX NOTES 675 (May 31, 2011); Billy Hamilton, Ghost Suburbs and Bahr Boomers: .4n Unhealthy Mix Pr the Property Tax, 61 ST. TAX NOTES 75 (July 4. 2011) (noting that long-term demographic trends suggest weakness of property tax base); see also 2011 N.Y. Laws Ch. 97 (bill passed limiting New York property taxes); Joe Hanel, Group Files Ballot Initiative on Property Tax Cuts, 61 ST. TAX NOTES 13 (July 4, 2011) (property tax limiting ballot initiative filed in Arizona).

(17.) How much the federal government can influence state tax policy through the federal income tax is addressed infra Part V.A.

(18.) Cf Stark, supra note 13, at 412 16 (federal interest in sub-national stability); id. at 438-39 (stability of property tax).

(19.) See, e.g., John L. Mikesell & Daniel R. Mullins, State and Local Revenue Yield and Stability in the Great Recession, 55 ST. TAX NOTES 267, 273 (Jan. 25, 2010) (finding that even during this last recession the property tax was much more stable than any other tax base, particularly the corporate income tax); see also discussion infra Part IV.B.1.

(20.) See, e.g., Super, supra note 14, at 2611 14, 2648-52.

(21.) Shaviro, supra note 14, at 975, 979-85.

(22.) See infra Part IV.B.2.a.

(23.) Certain reforms, such as instituting "circuit breakers," can make the property tax more progressive. Yet instituting any such reforms is not in the control of the federal government (though they can be encouraged) and, in fact, there are large differences in how the states with circuit breaker programs implement them and these variations in part reflect divergence on thorny issues (such as how to treat renters). See, e.g., Properly Tax Circuit Breakers, POLICY BRIEF (Inst. on Taxation & Econ. Policy, Washington, DC), Sept. 2011. available at Furthermore, making at least part of the SALT deduction an above the line deduction--a proposal of this paper and an initiative that is within the power of the federal government arguably enhances equity since more lower income people can take the deduction, but only in proportion to their marginal tax rate and only if they own property. The equity argument of this Article cannot therefore rely on this aspect of its proposed reforms. Of course, the administrative ease of making this (suboptimal) reform is a. (weak) equity argument in favor of this Article's reform proposals.

(24.) David Gamage, Preventing State Budget Crises: Redefining "Tax Cuts" and "Tax Hikes", 98 CAL. L. REV. 749, 785 (2010); Super. supra note 14, at 2614, 2632-34. Note that one could also argue, following Kaplow, that since the shift to the property tax is efficiency-enhancing then we should make that shift and use the income tax to make the shift distributionally neutral. See generally Louis KAPLOW. THE THEORY OF TAXATION AND PUBLIC ECONOMICS (2008). 1 would be happy with the use of such an expedient but the argument of this paper is that a shift to the property tax enhances equity even before instituting income tax adjustments.

(25.) Kaplow, supra note 14, at 413-20.

(26.) See NAT'L COMM'N, supra note 11, at 31.

(27.) Kaplow, supra note 14, at 432-33.

(28.) See Brian Galle, A Republic of the Mind: Cognitive Biases, Fiscal Federalism, and Section 164 of the Tax Code, 82 IND. L.J. 673, 676-79 (2007); see also Marika Cabral & Caroline Hoxby, The Hated Property Tax: Salience, Tax Rates, and Tax Revolts (2010) (unpublished manuscript, on file with Stanford University), available at http://www.stanfordedu/-~mcabral/Tax_Sallence.pdf

(29.) Kirk J. Stark, Rich States, Poor States: Assessing the Design and Effect of a U.S. Fiscal Equalization Regime, 63 TAX L. REV. 957, 1004-05 (2010).

(30.) Stark is aware that this is not the American tradition of federalism and that the political challenges are daunting. Stark, supra note 29, at 957 -58, 1007-08.

(31.) Geoffrey Brennan & Jonathan Pincus, Fiscal Equity in Federal Systems, 6 REV. L. & ECON. 347, 360 (2010).

(32.) Barry R. Weingast, Second Generation Fiscal Federalism: The Implications of Fiscal Incentives, 65 J. URB. ECON. 279, 285 (2009).

(33.) There is evidence of such moral hazard as to revenue sources. See, e.g.. Thiess Buettner, Equalization Transfers and Dynamic Fiscal Adjustment: Results Pr German Municipalities and the U.S.-German comparison. 19-20 (Inst. for Federalism and Intergovernmental Relations, Working Paper No, 2007-07, 2007), available at (finding that German sub-national governments, .freed from suffering the full ill effect of their financial decisions because of equalization, opted to fund themselves with more volatile taxes).

(34.) Gal le & Klick, supra note 13, at 211-17. For our purposes what is crucial is that for certain high income earners the AMT, section 55, takes away deductions that they could otherwise claim, like the SALT deduction. In an economic downturn, there are fewer such high income earners and so more taxpayers who take the SALT deduction, thereby putting more money into the national economy when and where it is most needed.

(35.) See, e.g., WALLACE E. OATES, FISCAL FEDERALISM -158 n.38 (1972); Giuseppe Eu.sepi & Richard E. Wagner, Polycentric Polity: Genuine vs. Spurious Federalism, 6 Rr.v. L. & ECON. 329, 337 (2010).

(36.) See, e.g., Reiner Einchenberger & David Stadelmann, How Federalism Protects Future Generations from Today's Public Debts, 6 REA/. L. & ECON. 395, 398 (2010).

(37.) See, e.g., Eusepi & Wagner, supra note 35, at 339.

(38.) See, e.g., Charles E. McLure Jr., The Nuttiness of State and Local Taxes--and the Nuttiness of Responses Thereto. 25 Si. TAX NOTES 841, 845 n.28 (Sept. 16, 2002).

(39.) Shaviro, supra note 14, at 975, 979.-85.

(40.) Ronald L. Watts & Paul Hobson, Fiscal Federalism in Germany, 41-46 (Dec. 2000) (unpublished manuscript, on file with the Association of Universities and Colleges of Canada), available at But see Lars R. Feld & Thushyanthan Baskaran. Federalism, Budget Deficits and Public Debt: On the Reform of Germany's Fiscal Constitution. 6 REv. L & ECON. 365, 374 (2010) (bemoaning fact that sub-national governments in Germany cannot control the rates of the primary taxes on which they rely).

(41.) No doubt the treatment here is not as broad as it might be, as it focuses on taxation issues and not issues, for example, of regulation. 1 hope that considering the almost 5100 billion at issue in these provisions (and the possibly bigger impact their redesign might have on the states) is broad enough to make a significant contribution. For a broader analysis, and one with which I largely agree (and draw from), see generally Super, supra note 14. Even this argument is not as broad as it might be, as a complete argument would also consider federal securities law relating to municipal finance and federal municipal bankruptcy law.

(42.) See, for example, the continuing debate as to what a tax expenditure is in practice. The statutory definition has not led to consensus. See, e.g., JCT, supra note 5, at 3-5 (summarizing issues and the JCT's current approach, which is a return to an approach it had modified in 2008); David A. Weisbach & Jacob Nussim, The Integration of Tax and Spending Programs, 113 YALE L.J. 955, 972 -82 (2004) (summarizing and criticizing tax expenditure concept.).

(43.) Weisbach & Nussim, supra note 42, at 957-83.

(44.) I am indebted to several students for the details of this analogy, though Weisbach and Nussim do themselves use the NIMBY analogy generally. See id. at 969.

(45.) The concern might not be with the Code as an abstract matter, but with complicating the Code prag, niatically. There is a good argument to be made against making paying taxes harder for the average taxpayer. See, e.g., Joint Comm'n on Taxation, A Reconsideration of Tax Expenditure Analysis 37 (2008). If this is the concern, then the reforms proposed here--especially just tweaking the above the line deductions--should pass muster.

(46.) See, e.g., OATES, supra note 35, at 30; Richard A. Musgrave & Peggy B. Musgrave, Public Finance in Theory and Practice 606 (1973). If a single jurisdiction, say a city, engages in redistribution, then that city is, for example, likely to attract more beneficiaries in a mobile federation. Individuals are far less likely to make locational decisions based on the availability of redistribution at the national level.

(47.) Weisbach & Nussim, supra note 42, at 962-63,1023.

(48.) This argument is analogous to the argument of Galle and Klick that the federal government should pursue its stabilization role automatically through the tax system and not through a spending program once a crisis has begun. Galle & Klick, supra note 13, at 209.

(49.) See CAL. COMM'N, supra note 3, at 27; see also Stark, supra note 13, at 416 -19; Holcombe & Sobel supra note 1.

(50.) For the details of the decline of the property tax, see infra Part 111.F.

(51.) Cf Stark supra note 13, at 421 23 (summarizing research and arguments and coming to similar conclusion, though noting that some of the evidence is equivocal).

(52.) See, e.g., John Joseph Wallis and Barry R. Weingast, Dysfunctional or Optimal Institutions?: State Debt Limitations, the Structure of State and Local Governments, and the Finance of American Infrastructure, at table 2 (Feb. 2006) (unpublished manuscript, on file with University of Southern California), available at (data through 2002); Steven Maguire, State and Local Government Debt: An Analysis, Congressional Research Service Report for Congress, Mar. 31, 2011, at table A-2 (data from 2002 to 2009).

(53.) Gillette, supra note 14, at 1040-49; for the general principle that the central government should attend to inter-jurisdictional spillovers, see MUSGRAVE & MUSGRAVE supra note 46, at 609-10; GRUBER infra note 67, at 273.


(55.) Robert W. Wassmer & Ronald C. Fisher, Slate and Local Debt, 1992-2008, 61 ST. TAX NOTES 427, 428 (Aug. 15, 2011). Though I believe the evidence for the over-use and misuse of the federal financing subsidy is substantial, I plan to do further work on trying to disentangle the exact magnitude of the problem.

(56.) See, e.g., Legislative Analyst's Office, Cal Facts 2011: Debt-Service Ratio Rising, available at (warning that the debt service burden on California's General Fund has recently increased to 6% and could increase to 9%).

(57.) See Darien Shanske, Going Forward by Going Backward to Benefit Taxes, 3 CAL. J. PoL. & PoL'Y 1,2-3 (2011).

(58.)See generally Darien Shanske, Above All Else Slop Digging: Local Government Law as a (Partial) Cause ("and Solution) to the Current Financial Crisis, 43 Mai. J. L. REFORM 663 (2010).

(59.) Cf. Inman, supra note 10, at 68-69 (noting that the federal government has an interest in encouraging proper use of state and local debt (which is often not used properly), but not discussing the various federal financing subsidies).

(60.) See, e.g., MusGRAvr.& MUSORAVE, supra note 46, at 607.

(61.) See, e.g., Glenn Follette & Byron Lutz, Fiscal Policy in the United States: Automatic Stain Discretional:1., Fiscal Policy Actions and the Economy 16, 19 (Fed. Reserve Bd., Working Paper No. 2010-43, 2010).

(62.) See Richard F. Dye, What Will the Future Property Tax Look Like?, in The Property Tax and Local Autonomy 229-30 (Michael E. Bell et al. eds., 2010).

(63.) The classic modern statement of a role for local governments as creating the opportunity for democratic participation is Gerald Frug, The City as a Legal Concept, 93 HARV. L .Rev. 1059 (1980). Even theorists skeptical of the extent of Frug's arguments concede the practical normative import of his arguments. See, e.g., Richard Briffault, Our Localism: Part II--Localism and Legal Theory, 90 COLUM. L. REV. 346, 416 (1990) ("The idea of local governments as governments--as centers of collective decision making rather than as firms that supply goods to the municipal marketplace--is certainly the underpinning of the legal authority of local governments."). For an argument expressing similar skepticism as to the desirability and plausibility of market discipline alone controlling state and local finance, see Richard C. Schragger, Democracy and Debt, 121 Yale L.J. 860 (2012).

(64.) On the current, unsettled state of the law on public employee contracts, see James E. Spiotto, Chapter 9: The Last Resort for Financially Distressed Municipalities, in The Handbook of Municipal Bonds 145, 164-65 (Sylvan G. Feldstein & Frank J. Fabrozzi, eds., 2008); see also Int'l Bhd. of Elec. Workers, Local 2376 v. City of Vallejo (In re City of Vallejo), 432 B.R. 262 (E.D. Cal. 2010) (affirming bankruptcy court's rejection of public employee contracts only after, among other things, a balancing of the equities). As for other limits, see 11 U.S.C. [section] 109(c) (2011) (locality must choose bankruptcy); 11 U.S.C. [section] 904 (2011) (limited powers of federal courts); Kevin A. Kordana, Tax Increases in Municipal Bankruptcies, 83 VA. L. REV. 1035, 1059-67 (1997) (bankruptcy judge probably cannot require tax increases and should not).

(65.) And so I think commentators have been too quick to advocate an expansion of the bankruptcy option to states and/or generally to advocate less aid to states and localities ex post. See, e.g, David A. Skeel, Jr., Give States a Way to Go Bankrupt: It's the Best Option for Avoiding a Massive Federal Bailout, 3 CAL. J. POL. & POL'Y 19 (2011); Inman, supra note 10, at 69-70, 78.

(66.) See, e.g., McLure, supra note 38; see generally David G. Duff, Benefit Taxes and User Fees in Theory and Practice, 54 U. TORONTO. L.J. 391 (2004). I have made this argument in the California context in two related pieces. See Shanske, supra note 57; Darien Shanske, Putting the .California Constitution (Back) 10 Work: A Blueprint/Or Clearing Legal Roadblocks to Proper Infrastructure Finance, 54 ST. Tax Notes 567 (Nov. 23.2009).

(67.) Musgrave & Musgrave, supra note 46, at 195; Jonathan Gruber, Public Finance and Public Policy 231 (3d ed. 2010).

(68.) This is the so-called preference revelation problem. See, e.g., GRum.A. supra note 67, at 231-32.

(69.) See, e.g., Musgrave & Musgrave, supra note 46, at 196; Duff, supra note 66, at 393-94.

(70.) Musgrave & Musgrave, supra note 46, at 596-97; GRUBER. supra note 67, at 273-74; OATES, .supra note 35, at 35; Charles E. McClure Jr., The Tay Assignment Problem: Ruminations on How Theorr and Practice Depend on History, 54 NAT'L TAX J. 339,343-44,352 (2001). Note that traditional tax assignment theory also assigns the most stable taxes to the lowest levels of government precisely because the lowest level of governments are not in a position to undertake macroeconomic stabilization. Richard A. Musgrave, Who Should Tax, Where, and What?, in Tax Assignment in Federal Countries 2. 12-13 (Charles McLure Jr. ed., 1983.).

(71.) For instance, to the considerable extent that the local property tax is still used for school finance. See generally William A. Fischel, The Homevoter Hypothesis 39-71, 99-100 (200 I ).

(72.) See Musgrave, supra note 70, at 13.

(73.) Cal. Comm'n, supra note 3, at 32-33 (recent reformers from different political perspectives arguing that California should impose more taxes according to a benefit principle).

(74.) See, e.g., Richard A. Epstein, The Ubiquity of the Benefit Principle, 67 S. CAL. L. REV. 1369, 1409 (1994) (support of benefit principle from generally libertarian perspective).

(75.) Liam Murphy & Thomas Nagel, The Myth of Ownership 16-19, 85 (2002).

(76.) Richard M. Bird & Thomas Tsiopoulos. User Charges fin-Public Services: Potentials and Problems, 45 CAN. TAX J. 25 (2007).

(77.) See generally Ross E. Coe, Federalism's Vanguard: Local Government User Fees, 61 ST. TAX NOTES 561 (Aug. 29. 2011) (chronicling rise of fees and concomitant decline of property taxes since the 1970s). Coe also argues that an expansion in the use of fees should he contemplated as a stable source for local government finances, having given up, apparently, on property taxes. This is certainly a reasonable position, one I essentially agree with, but! do not think that fees can possibly expand to replace the entire property tax nor that the federal government has an interest in such a shift.

(78.) Kogan in a recent draft paper finds evidence that federal deductibility encourages the imposition of local taxes, but assumes that this "tax contagion" is inefficient because it lowers the tax price that voters must pay for local tax increases. Yet, Kogan does not entertain the argument--at the center of this paper--that, from the perspective of the federal government, the tax price for local property taxes is sub-optimally high. See Vladimir Kogan, Vertical Spillovers in Local Politics: How Federal Tax Laws Shape Voter Support for Local Tax Increases (Dec. 22, 2009) (unpublished manuscript, on file with the University of California, San Diego), available at

(79.) Suzanne Mettler recently identified the SALT deduction as a component of the "submerged state," this provision was placed in the Code with little fanfare and has since ballooned in importance. SUZANNE METTLER, THE SUBMERGED STATE 12, 16 (2011). As will become clear, I think a similar story can be told about the section 103 exclusion. Note that my concern (in contrast to that of Mettler) is not with revealing these provisions (not that I am opposed to that); rather, my aim is to rationalize these submerged provisions so that they can at least do some good.

(80.) Revenue Act of 1913, ch. 16, 38 Stat. 114, 167 (1913) (current version at 1, R.C. [section] 164). Indeed, a similar deduction was in the original code instituted during the Civil War, an issue that came up repeatedly during the debate as to whether to repeal the deduction as part of tax reform in 1985. See, e.g., Federal Income Tax Deduction for State and Local Taxes: Hearing Before the Subcomm. on Intergovernmental Relations of the S. Comm. on Governmental .Affairs. 99th Cong. 3. 26 (1985).

(81.) See, e.g., JEFFREY H. BIRNBAUM & ALAN S, MURRAY, SHOWDOWN AT GUCCI GULCH 113-16 (1987) (detailing part of the battle).

(82.) See 1.R.C. [section] 164(b)(5).


(84.) Revenue Act of 1913, ch. 16, 38 Stat. 14.

(85.) Early commentators, like the Blakeys, glossed this provision as denying the deduction for "ordinary special assessments." ROY G. BLAKEY & GLADYS C. BLAKEY, THE FEDERAL INCOME TAX 96 (1940).

(86.) 50 CONG. REC. 508 (1913) (Statement of Mr. Hull). For the central role of Congressman Hull in designing and advocating for the income tax, see BLAKEY & BLAKEY, supra note 85, at 75-76.

(87.) 50 CONG. REC. 508 (1913) (Statements of Mr. Hull and Mr. Bartlett).

(88.) See South Carolina v. Baker, 485 U.S. 505 (1988). For proposals to reform the exemption, see supra text accompanying note 12; see also Public Employee Pension Transparency Act, H.R. 567. 112th Cong. (2011) (the Act would place additional disclosure requirements on issuers of tax-exempt bonds).

(89.) See generally Kevin M. Yamamoto, A Proposal for the Elimination of the Exclusion for Slate Bond Interest, 50 FLA. L. REV. 145, 151 (1998).

(90.) See Gillette, supra note 14, at 1042-46.

(91.) There were some early engagements with the tax exemption; FDR, for example, tried and failed, to eliminate the tax exemption in 1938. See DENNIS ZIMMERMAN, THE PRIVATE USE Or TAX-EXEMPT BONDS 43-44 (1990); Yamamoto, supra note 89, at 167-70.

(92.) PAUL R. MCDANIEL ET AL., FEDERAL INCOME TAXATION 725-27 (5th ed. 2004).

(93.) Internal Revenue Service, Statistics of Income Division, Individual Income Tax Returns, Pub. No. 1304 TY 2008. table 1.2, available at http//

(94.) Wealthier taxpayers also benefit more because the deduction is more valuable the higher one's marginal tax rate. See Stark, supra note 18, at 426.

(95.) H.R. REP. NO. 110-606, at 42 (2008).

(96.) I.R.C. [section] 54AA.

(97.) I.R.C. [section] 54AA(g).

(98.) U.S. DEP'T OF TREASURY, GENERAL EXPLANATIONS OF THE ADMINISTRATION'S FISCAL YEAR 2012 REVENUE PROPOSALS 20 (2011). There is also evidence that, indeed, the BABs program was popular for a reason, namely that it lowered borrowing costs relative to traditional section 103 borrowings. Gao Liu & Dwight Denison, Indirect and Direct Subsidies .for Cost of Government Capital: Comparing Tax-exempt Bonds and Build America Bonds 18-19 (Martin School Workshop, University of Kentucky, Working Paper, 2011), available at ("[I]t is found that BABs have a lower after-subsidy interest cost of 54 basis points lower than that of tax exempt bonds. After controlling for the difference of other factors by setting all other variables at their mean values, the estimated saving is even larger. Issuers can save 72 basis points ... by issuing BABs instead of tax exempt bonds."). But see Mark D. Robbins & Bill Simonsen, Build America Bonds, 30 MUN. FIN. J. 53, 67-68, 74 (2010) (BABs were more expensive than comparable taxable bonds). These two papers could be consistent with one another: BABs might have been a better deal for municipal issuers because they received a greater federal subsidy, but the federal government did not get a better deal because the federal subsidy is scaled to interest rates and the interest rates that municipal issuers received were higher than anticipated. To use numbers, let us imagine that the ordinary tax exempt borrowing rate was 8% and the ordinary taxable rate was 10%. The federal government might have hoped that a municipality would borrow at 10% and that, accordingly, its subsidy rate would be 3.5%. Assume, however, that the municipality in fact borrows at 11% and the federal government must pay 3.85%. Yet, even at 11%, the real borrowing rate for the municipality is 7.15%, still better than the regular section 103 rate.

(99.) See U.S. DEP'T OF TREASURY, supra note 98, at 21.

(100.) Id. There is academic research supporting this rate. See Liu & Denison, supra note 98, at 18-20 (finding the neutral rate to be 25%). If all purchasers of BABs were taxable at this rate (25%), then the BAB program would he a wash for the federal government because it would recoup its subsidy through taxing the investors. BABs, however, by expanding the pool of possible investors, have likely expanded the pool to individuals with a marginal rate lower than the reimbursement rate and to entities that do not pay income tax at all. Of course, all this market expansion should lower interest rates on BABs relative to taxable bonds, though this does not seem to have happened yet. See Robbins & Simonsen, supra note 98, at 66-68 (evidence on expanding the pool of investors in BABs relative to section 103 bonds, but also evidence that BABs issued at higher rate than comparable taxable bonds).

(101.) T.A. Garrett & R.M. Rhine, On the Size and Growth of Government, 88 FED. RES. BANK OF ST. LOUIS REV. 13, 27 (2006).

(102.) W. Elliot Brownlee, Tax Regimes, National Crisis and Slate-building, in FUNDING THE MODERN AMERICAN STATE 93 (W. Elliot Brownlee ed., 1996); Dennis. Ventry, The Accidental Deduction: A History and Critique of the Tax Subsidy for Mortgage Interest. 72 LAW & CONTEMP PROBS. 233 (2010) (similar history about the rise of the mortgage interest deduction).

(103.) 26 U.S.C. [section] 68 contains a complicated phase-out of itemized deductions, including the SALT deduction. Section 68 was itself subject to phase-out as part of the 2001 Bush tax cuts, but this phase-out is itself set to end in 2012. Tax Relief Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No. I I I -312. 124 Stat. 396, [section] 101(a) (codified as amended in scattered sections of 26 U.S.C.). For a helpful summary, see MCDANIEL ET AL., supra note 92, at 749-50.

(104.) Cf: Kim Reuben, The Impact of Repealing State and Local Tax Deduclibility, 37 ST. TAx NOTES 497 (Aug. 15, 2005).

(105.) Jennifer Gravelle & Sally Wallace, Overview of the Trends in Property Tax Base Erosion, in EROSION OF THE PROPERTY TAX BASE 43 (Augustine et al. eds., 2009).

(106.) Eric M. Zolt, Inequality, Collective Action, and Taxing and Spending Patterns Of State and Local Governments, 62 TAX L. REV. 445, 497 (2009); HOLCOMBE & SO13EL, supra note 1, at 51; Cabral & Hoxby, supra note 28, at 23-24.

(107.) John Joseph Wallis, A History of the Property Tax in America, in PROPERTY TAXATION AND LOCAL GOVERNMENT FINANCES 123 (Wallace E. Oates ed., 2001).

(108.) Id. An oft-cited rule of thumb is that the property tax should account for twenty to thirty percent of state-local revenue. See, e.g., RONALD JOHN Hv & WILLIAM L. WAUGH, JR., STATE AND LOCAL TAX POLICIES: A COMPARATIVE HANDBOOK 49 (1995) (following Robert Kleine and John Shannon, CHARACTERISTICS OF A BALANCED AND MODERATE STATE-LOCAL REVENUE SYSTEM (1985)). Though I agree that the property tax is under-utilized, 1 explain infra Part M.G. why I am not relying on a particular percentage as a one-size-fits-all model.

(109.) Dale Krane et at.. Devolution, Fiscal Federalism, and the Changing Patterns of Municipal Revenues: The Mismatch between Theory and Reality, 14 J. PUB. ADMIN. RES. & THEORY 513, 523 (2004).

(110.) See GraveIle & Wallace, supra note 105, at 18-19.

(111.) Stephen Diamond, The Death and Transfiguration of Benefit Taxation: Special Assessments in Nineteenth-C'enturv1tnerica, 22 J. LEGAL STUD. 201, 202 (1983). ("In the United States, the special assessment developed simultaneously with the general property tax as one of the twin financial pillars of state and local government"); see also VICTOR ROSEWATER. SPECIAL ASSESSMENTS: A STUDY IN MUNICIPAL FINANCE 83 (1893) (reporting that assessments could account for as much as fifty percent of receipts for many cities in 1890, including San Francisco and Chicago).

(112.) One of the rare (and early) cases about this provision is Beljast Investment Co. v. Commissioner, 17 B.T.A. 213 (1929). The holding of this case is that the federal courts will not second-guess state and local law as to what is or is not a valid assessment. Id. at 231. From a historical perspective, more interesting is the extensive list of assessments that the taxpayer attempted to deduct ($6854.11 in 1918 alone), id. at 219, and this description of local public finance in Kansas City at the time:
  General public improvements in Kansas City, Mo., are not
  paid for in full out of general taxes. The levy for
  taxes for city purposes is limited by the state law and
  it is impossible for the city to levy a general tax
  sufficient to pay for the general public improvements
  that are carried on in the city. In order to provide
  sufficient money to make various improvements the city
  resorts to creating special benefit districts. The property
  within such districts is then taxed in proportion to the
  benefit which the city determines the property derives from
  the improvement. The benefit district is passed upon by the
  common council. There is then a public hearing. Id. at 220.

(113.) There was a ninety percent drop in assessment revenue 'between 1930 and 1940 in cities with a population over 500,000. Donald C. Shoup, Financing Public Investment by Dejerred Special Assessment, 33 NAT'L TAX J.413,413 (1980).

(114.) Zimmerman locates the explosion of debt issuance in the 1960s, see ZIMMERMAN, supra note 91, at 88.


(116.) For more on the mechanics, see id. at 7-8.

(117.) See I.R.C. [section] 148 (1986).

(118.) See I.R.C. [section] 141 (1986). For more on these rules. see Darien Shanske, Attention. Carbon Auditors: There's Low-Hanging Fruit in the PAR Regs, 127 TAX NOTES 693 (May 10, 2010).

(119.) Many other examples are possible; notably there is the continued use of public funding to build stadia for private sports teams. See, e.g., Logan E. Gans, Take Me Om to the Ball Game, But Should the Crowd's Taxes Pay for It?, 29 VA. TAX. REV. 751 (2010).

(120.) See generally Shanskc, supra note 118.

(121.) See id.; see also Shanske, supra note 58 (arguing that the states themselves can and should bar localities from such practices).

(122.) One problem is that not all meritorious projects should be financed by the property tax--say a bridge to be financed by tolls or a wastewater treatment plant by fees. Yet this is not an insuperable obstacle. Such projects, for instance, could receive the tax-exemption (or BAB subsidy) if approved, for example, by the (proposed) National Infrastructure Bank. See National Infrastructure Development Bank Act of 2011, H.R. 402, 112th Cong. (2011). The idea would be to limit state and local government initiative to projects that are property-tax based, but allow them to fund other kinds of projects only if there is some showing that the project is of the kind that the national government should be subsidizing.

(123). ARISTOTLE, NICOMACHEAN ETHICS 1.3 (Irwin translation).

(124) Cf. OATES, supra note 35, at 121 (following Richard Lipsey & Kelvin Lancaster, The General Theory of the Second Best, 24 REV. ECON. STUD. 11 (1956)).

(125) And I do not, nor do I know of one, especially since such a theory would have to take into account the larger economic institutional background. See, e.g., Linda Sugin, A Philosophical Objection to the Optimal Tax Model, 64 TAXL. REV., 229, 279-81 (2011).

(126.) Cf. H.F. Ladd & W.M. Gentry, State Tax Structure and Multiple Policy Objectives. 47 NAT'L TAX J. 747 (1994) (finding little support for uniform policy prescription for state tax structures).

(127.) See. e.g., J.P. Suyderhoud, State-Local Revenue Diversification, Balance, and Fiscal Peyrformance, 22 PUB. FIN. REV, 168 (1994) (finding improved fiscal performance associated with revenue diversification). Whether advisable or not, and at least partially in response to limitations in the property tax, local governments have followed states in diversifying their revenue sources, including to income and sales taxes. See Krane et al., supra note 109, at 525.

(128.) Gravelle & Wallace, supra note 105, at 37.

(129.) Wallis, supra note 107, at 178.

(130.) Nordlinger v. Hahn, 505 U.S. 1, 3-4 (1992) (Supreme Court emphasizes role of inflation).

(131.) Robert P. Inman, Financing Cities. in A COMPANION TO URBAN ECONOMICS 311, 323 (Richard J. Arnott & Daniel P. McMillen eds., 2006) (noting in particular the paralysis caused by multiple overlapping entities).


(133.) For the now classic argument that the California Serrano Supreme Court decisions caused Proposition 13, see FISCHEL, supra note 71, at 98-128. For a discussion of some of the other contingencies and observations on the limit of Fischel's argument, see Darien Shanske, What the Original Property Tax Revolutionaries Wanted (It is Not What You Think), 1 CAL. J. POL & POL'Y 18 (2009) (reviewing ISAAC W. MARTIN, THE PERMANENT PROPERTY TAX REVOLT: How THE PROPERTY TAX TRANSFORMED AMERICAN POLITICS (2008)).

(134.) Martin, supra note 132, at 108-20. And, it should be noted that Proposition 13's particular solution to the liquidity problem--across-the-board assessment and rate limitation is "among the least effective, equitable, and efficient strategies available for providing property tax relief" Terri A. Sexton, Assessment Limits as a Means of Limiting Homeowner Property Taxes, in EROSION OF THE PROPERTY TAX BASE: TRENDS, CAUSES, AND CONSEQUENCES, supra note 105, at 117, 139 (2009).

(135.) See Shofroth & Hamilton, supra note 16.

(136.) "Political salience" refers, roughly, to the salience of a tax when voters make voting decision. This is in contrast to "market salience," which refers to the salience of a tax when a consumer makes a market decision. David Garnage & Darien Shanske, Three Essays On Tax Salience: Market Salience and Political Salience, 65 TAX L. REV. (forthcoming 2012). Note the "appears." As indicated supra at II.A, the empirical study of salience is just beginning.

(137.) Joan M. Youngman, Property Taxation, in TAX JUSTICE 223 (Joseph J. Thorndike & Dennis J. Ventry Jr., eds., 2002); Cabral & Hoxby, supra note 28, at 1.

(138.) Such general concerns are summarized in Gamage & Shanske, supra note 136, at Part I.B.3.

(139.) See id. and Part III.

(140.) Brian Galle. Hidden Taxes, 87 WASH. U. L. REV. 59, 96-97 (2009).

(141.) Cabral & Hoxby, supra note 28, at 21-22. Lilian Faulhaber would label this phenomenon "hypersalience." Lilian V. Faulhaber, The Hidden Limits of the Charitable Deduction: An Introduction to "Hypersalienee", (Bos. Univ. Sch. Of Law, Working Paper No. 12-02, 20 1 2), available at

(142.) See discussion infra Part IV.B.2.a.

(143) The decline in the use of the property tax may be connected to another dynamic that may justify federal intervention: Baumol's Cost Disease. Cost disease is a characteristic of certain labor-intensive activities that cannot be made significantly and consistently more productive through the investment of capital. The classic example involves an orchestra. See generally W.J. BAUMOL & N.G. BOWEN, PERFORMING ARTS: TILE ECONOMIC DILEMMA (1966). As many other goods and services have gotten far cheaper to produce (e.g., food and transportation), the investment required to have an orchestra perform a Beethoven symphony has changed little, and thus these labor intensive activities have become relatively more expensive. It has long been noted that many traditional government functions likely suffer from the cost disease; consider the labor involved in education or policing. W.J. Baumol, The Microeconomics of Unbalanced Growth: The Anatomy of Urban Crisis, 57 AMER. ECON. REV. 415, 423 (1967). Baumol himself went on to argue that local governments are going to have a particularly difficult time countering the cost disease because they simultaneously produce activities prone to cost disease and are less able to raise revenues--for instance because of jurisdictional competition. Id. at 426. Thus, Baumol concluded that the federal government should do more to aid local governments. Id.
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Title Annotation:I. Introduction through III. Background: A Short, Broad and Tendentious History of the Federal-State Tax Interaction, with footnotes, p. 413-447
Author:Shanske, Darien
Publication:Virginia Tax Review
Date:Jan 1, 2012
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