Tax and Financial Articles

How Floridians Indirectly Pay State Income Taxes

Those of us who live in Florida are fortunate to live in a state where there is no state income tax.  But are we completely off the hook?  Not exactly.  High state income states can actually shift some of the tax burden that they impose on their residents onto taxpayers elsewhere through the state income tax deduction available on the federal tax return.

For example, let’s take a high earner who lives in New Jersey and makes about a million dollars. That taxpayer will pay about $70K per year in NJ state income tax.  On his federal return, he can deduct $70K on Schedule A as an itemized deduction.  Using a 35% marginal rate, the taxpayer saves approximately $25K on his Federal taxes. Therefore, the $70K in NJ tax only costs the taxpayer $45K.  But NJ gets the full $70K.  

Who pays the other $25K?  That $25K is lost revenue to the Federal Treasury, so in effect, the tax burden is shifted to everyone else.  Because residents of other high state income tax states also receive a similar deduction, the tax burden ultimately gets shifted to those taxpayers in low state income tax states.   

In addition, the higher the Federal income tax rate, the greater the subsidy effect.  In other words, if the top marginal income tax rate at the federal level was 50%, the $70K would only cost the NJ taxpayer $35K, shifting  the other $35K to taxpayers everywhere else.

There are some proposals floating around Capitol Hill to lower Federal rates and eliminate deductions, including the deduction for state and local income tax.    However, because the deductibility of state income tax combined with a high Federal rate is a great way for states to shift tax burdens, those proposals are likely to get a lot of resistance from those states with high state income taxes.