Tax-reform peril

Last week, President Obama hinted at an idea that could hit New York, New Jersey and other high-tax states where it hurts: in their residents’ right to deduct state and local tax tabs from their federal tax bills.

In the wake of his still shaky deal with Republicans to keep the Bush tax cuts for two years, Obama seized the offensive last Thursday. “We’re going to have a big debate about taxes,” he promised. “We’ve got to have tax reform . . . We’ve got to simplify the system.”

That means poring through the federal tax code line by line to kill off as many special-interest tax breaks as possible. That way, we may have money to cut corporate rates and still bring in as much federal revenue or more than today’s code.

Obama’s right — we need to do this job. In the quarter-century since the Reagan tax reform (which allowed the top rate to drop by more than a quarter, from 50 percent to 33 percent), special tax breaks have piled up again. Today, taxpayers spend a trillion dollars a year on tax goodies.

Realize: These tax breaks are more like government spending than any actual tax cut. Each break lets someone pay less to the government than he otherwise would, because Uncle Sam officially approves of his behavior. Those who don’t engage in that behavior have to pay more to make up the difference.

If you sell your house at a profit, you probably don’t have to pay any tax on the gain — because someone else is paying a tax on profit from some other, perhaps more productive, investment.

Many tax breaks make little sense — a special interest has simply persuaded the right people in Congress to grant a favor — but the biggest breaks have a lot of beneficiaries, such as those for home mortgages and health insurance.

Another biggie is the break for state and local taxes. The feds lose about $50 billion a year in allowing people to deduct some state and local tax payments from their income. (Most everyone can deduct some property taxes, although they have to choose between income or sales taxes.)

This break plainly subsidizies higher spending in higher-tax states. It means that if you’re living in New York, Connecticut or New Jersey (all in the top 10 on the Tax Foundation’s list of highest-tax states), you’re paying more into state and local coffers partly because Washington subsidizes your state’s tax collection.

So if the feds end this tax break, more affluent earners in these states — that is, people who itemize their deductions — would have to pay significantly more.

Supporters of that reform will say it’s only fair. The pain wouldn’t really be the feds’ fault. These taxpayers should pressure governors, mayors and legislatures to keep taxes (and spending) down.

Of course, this is a tough tax break to kill. In 1985, President Ronald Reagan’s tax-reform panel wanted to end state and local tax deductions. But state leaders, led by then-Gov. Mario Cuomo, marshaled their wealthier residents to fight the proposal, calling it a “rip-off” and not reform.

Reagan quickly found that pitting high-tax states against low-tax ones didn’t work as a political strategy. Even low-tax states were adamant about keeping their deductibility and didn’t much care whether other states benefited more. Reagan ditched the idea, rather than see tax reform die.

Yet the Alternative Minimum Tax adds another wrinkle to any new reform drive. It reduces the value of almost all tax breaks, so wealthier taxpayers already face big limits on their ability to deduct state and local taxes. It might be harder to mobilize anger at reform that ends the deduction for everyone, this time around.

Yet even talk of ending this tax break could instill some useful fear. If New Yorkers who earn in the low six figures — that is, people who still benefit from deductibility — worry that tax reform will compound state and local tax hikes, they may oppose such hikes even more forcefully.

In an environment where pols are running scared of new levies, headlines on how state and local taxes could cost New Yorkers even more, thanks to potential change in federal policy, could make the pols run a little faster.

Certainly, any discussion of tax reform will serve as another alarm for Gov.-elect Andrew Cuomo. Even if the feds ultimately shy away from hitting state and local taxes, Washington, as it struggles to close its own budget deficits, likely won’t be offering more aid to cities and states anytime soon.

Nicole Gelinas is a contributing editor to the Manhattan Institute’s City Journal.