President Reagan's tax plan may also `reform' some unwilling cities and states

A battle royal is in the making. If any element of President Reagan's sweeping tax-reform package has ignited public and congressional debate, it is the proposal to end the deduction for state and local taxes.

The controversy not only touches individual taxpayers. It also affects the relationship between Washington and states and cities.

``That probably will be the most controversial section because it's big money,'' says Rep. Dan Rostenkowski (D) of Illinois, chairman of the powerful House Ways and Means Committee.

Governors and mayors are lined up to testify before his committee, he told reporters at a breakfast meeting Thursday, and the issue will be a ``very sticky point'' politically as his panel hammers out a reform bill.

In the end, says Mr. Rostenkowski, it is unlikely that opposition from the 15 high-tax states -- which are mostly in the Northeast and Midwest -- will be enough to stop this part of the tax-reform plan, although modifications are possible.

The elimination of this deduction would constitute the largest source of federal revenue to make up for the losses stemming from the cuts in marginal tax rates. The Treasury Department estimates that it would gain some $38 million in annual revenue by 1988. Without repealing this deduction, there can be no tax reform, Treasury argues.

The administration also argues its case on the issue of fairness. Only about one-third of all taxpayers itemize deductions, including state and local taxes. So deductibility ``forces taxpayers in low-tax states to subsidize the big spending policies of a few high-tax states,'' Mr. Reagan says.

Some governors and mayors are up in arms, however. They argue that the reform will make it more difficult for states and cities to raise taxes for public services because residents will be less likely to vote for taxes they can't deduct.

They point out that the administration sharply reduced domestic programs in its first term, shifting responsibility for many services to the states. The budget for fiscal 1986 will further curtail aid to states, including general revenue sharing, community block grants, and urban development grants. All of this comes on top of state tax-reform efforts, such as those in California and Massachusetts, that sharply restricted tax increases.

Ending the deduction for state and local taxes is thus seen as another assault on state and local government -- a strategy that fits in with the President's goal of shrinking government at all levels.

``This comes at a time when the federal government is dumping lots of responsibility on the states. Eliminating deductibility will make it much more difficult for states and local governments to replace lost federal aid,'' says Steven Gold, an official of the National Conference of State Legislatures.

Mr. Gold says that according to administration projections, federal aid to the states will drop by 25 percent in real terms between 1981-88. The biggest cuts will come in the next three years.

From the standpoint of an ideal reform, tax experts favor the elimination of the state- and local-tax deduction. But they suggest some adustment may be in order.

``It is an inefficient way for federal government to be subsidizing state and local expenditures, and in Treasury's original plan it was entirely justified,'' says Charles R. Hulten, a senior research associate at the Urban Institute. ``Over the years the state and local sector has not been abused by the federal government in terms of the largess it has received.''

But inasmuch as the administration made concessions on capital gains and a number of other areas, ``it seems hard to justify giving state and local taxes the full treatment in the present plan,'' he says.

Many states and localities are irked that the administration is singling them out as the major source of savings instead of going after other deductions also, including deductions for charitable contributions and all home-mortgage interest. They note that more taxpayers are itemizing state and local taxes than are itemizing other deductions.

According to the National Association of State Budget Officials (NASBO), some 33 million taxpayers (out of 95 million) itemized state and local tax deductions in 1982, the latest year for which data are available; about 30 million itemized charitable deductions; and 24.5 million itemized mortgage-interest deductions.

While the administration argues that state- and local-tax deductions subsidize itemizers in the higher-income groups, opponents say the same argument can be made for deductions, such as mortgage interest on homes in places of high incomes and property values.

``Who benefits from high-valued houses in Palm Springs?'' asks Gerald Miller, executive director of NASBO. ``Yes, high-tax people do benefit more from state- and local-tax deductions, but that's irrelevant if you're willing to be honest and look at each deduction.''

But the most fundamental concern is that ending the deduction for state and local taxes will seriously impede the ability of local jurisdictions to provide education, housing, health care, and other services for the poor. The states with the highest taxes, above all New York, have the largest concentrations of poor people. Moreover, unlike charitable contributions or mortgage payments, taxpayers have no choice in paying state and local taxes.

``Reagan argues that he's fighting the special interests,'' says Gold. ``But in this case you're talking about services, not a special interest, as in other features of the tax reform. And deductibility is not just a quid pro quo for direct services. It is the poor who benefit.''

Some state and local jurisdictions are also concerned about another ingredient of the Reagan tax package: removal of the deduction for interest on municipal bonds -- such as industrial development bonds -- that involve some form of private participation and do not directly benefit a governmental unit.

It is unclear what nongovernmental bonds the administration intends to eliminate from tax exemption. But ending municipal-bond interest deductions could boost utility bills, fees at not-for-profit hospitals, housing rent, and other services, critics of the reform charge.

The administration argues that state and local governments have increasingly used tax-exempt financing to raise money for private businesses, residential mortgages, and nonprofit corporations. This, say Treasury officials, has eroded the federal tax base, forcing increases in tax rates on nonexempt income, and created distortions in the economy.

``Private-purpose bonds have come to be an abuse of the system,'' agrees Mr. Hulten. ``The larger question is whether to use the tax code to further special social and economic objectives. Too much of a good thing becomes a bad thing. So many `good' things have piled up that the revenue base has been lost and this has set the stage for the [budget] deficits.''

Critics believe that Reagan is singling out state and local governments in part because these are easiest to go after. Other interest groups, such as charity organizations, are politically stronger and can more easily mobilize their constituencies.