The type of federal tax reform under active consideration for the past three years or so–broadening the base of taxable income and applying lower rates to that base–can have a major impact on state and local governments and their economic development strategies. President Reagan’s 1985 plan for tax reform (Treasury II) would have affected state and local governments more than any other sector of the economy. Those provisions were substantially changed in the Tax Reform Act of 1986, and the state-local sector did not escape unscathed.

This paper explores the likely effects of the major provisions affecting state and local governments, specifically the restrictions on the deductibility of state and local taxes and on tax-exempt borrowing by state and local governments. The strongest of such provisions were not enacted in 1986. Given the precarious state of the federal budget, however, some of the revenue-enhancing tax reform proposals may be adopted in the future to reduce the deficit. Such measures are particularly attractive because they do not involve across-the-board increases in tax rates. Indeed, in 1982 and 1983, Congressional committees devoted a good deal of attention to these measures, and Congress enacted some minor changes as revenue-increasing rather than tax reform measures. Moreover, if the restrictions on state-local tax deductibility and state-local tax-exempt borrowing enacted in 1986 do not yield the revenue projected, Congress may act further along the same lines. Therefore, in this paper, I will address both the provisions of the 1986 Act and the more severe restrictions of the earlier tax reform proposals that concern state-local tax deductibility and tax-exempt borrowing.