A Republic of the Mind: Cognitive Biases, Fiscal Federalism, and the Tax Code


Brian Galle


Our federal government annually donates more than $75 billion in potential revenue to the States under section 164 of the Tax Code, the provision allowing itemizing taxpayers to deduct the cost of the state and local income, property, and sales taxes they paid during the tax year. This Article argues that expenditure may be a massive mistake. The deduction is, in theory, supposed to further federalism, by shifting revenues -- and therefore regulation -- downwards from the federal government to states and their local subsidiaries. What few commentators seem yet to have recognized, though, is that using the deduction for that end, rather than some other fiscal tool, may have the perverse effect of undermining the efficiency, transparency, and even the democratic character of those local governments.

The eye-popping size of the $75 billion number makes section 164 a perennial issue in tax policy circles, and, as one of the deductions omitted from the Alternative Minimum Tax’s parallel tax universe, the section is also a key component of debates about the AMT. Recent Bush administration rumblings that the deduction may be on their agenda for reform, even aside from any possible AMT fix, make a reconsideration of section 164 especially timely.

It has been almost a decade since the last major legal academic examination of the merits of the deduction. This Article begins, humbly, by attempting to update that earlier work with recent developments, such as our expanded understanding of the limits of taxpayers’ capacity to analyze their own economic situation, and the need for more cooperative tax enforcement in a “flatter” world. The Article proposes a novel justification for the deduction, based on my claim that cognitive biases and other factors in the political economy of taxation would, absent the deduction, prevent states from sharing the burden of tax enforcement with the federal government.

More generally, however, my goal here is to show that section 164 is about more than (boatloads of) money. Other commentators, especially economists, have recognized that the deduction may shift the locus of regulation from federal to state and local governments. In this Article I argue that the deduction may play a large but currently underappreciated role not only in the relative sizes of local and federal governments but also in the structure and effectiveness of sub-national governments. Local governments develop in response both to direct political demands and also the indirect pressure generated by the threat of “exit,” or out-migration to a more efficient or more responsive jurisdiction. The deduction, I argue, significantly affects both of these factors -- most obviously by reducing exit pressures, but also by in more subtle ways transforming the processes of direct politics.

Thus, what we should think about section 164 depends on much more than the bottom of a balance sheet. Any fully considered judgment must include our philosophy of mind, our plan for the individual states’ place in an international marketplace, and our optimal design for good local government. Seventy-five billion? That’s nothin’.


State and Local Government Law | Taxation-Federal | Taxation-State and Local | Tax Law

Date of this Version

March 2006