Limit the value of itemized deductions to 28 percent
Taxpayers may reduce their taxable income by subtracting either the appropriate standard deduction or their itemized deductions for medical expenditures, state and local taxes, mortgage interest, charitable contributions, and other allowed expenses. Because deductions reduce taxable income, their effect on tax liability depends on the taxpayer’s tax bracket. For example, itemized deductions totaling $10,000 reduce taxes for a person in the 15 percent bracket by $1,500 (15 percent of $10,000) but cut taxes by $3,500 for a person in the 35 percent bracket (35 percent of $10,000). The rationale for itemized deductions is that allowable expenses reduce the taxpayer’s ability-to-pay and should therefore not count in taxable income.
The president proposes limiting the value of deductions to no more than 28 percent starting in 2011. That limit would increase taxes for taxpayers whose tax rate exceeds 28 percent—those who would face 36 percent and 39.6 percent tax rates in 2011.
This change would interact with Pease (the limitation on itemized deductions). Relative to having neither provision, the 28 percent cap on the value of deductions and Pease would combine to limit the tax savings from itemizable expenses to as little as 5.6 percent of those expenses—28 percent of the 20 percent minimum deduction allowed under Pease. That value is just one-seventh of the 39.6 percent maximum tax savings that taxpayers in the top tax bracket would get if neither Pease nor the 28 percent limitation were imposed.
The tax treatment of itemized deductions reduces the after-tax cost of allowed expenditures. For example, a taxpayer in the 35 percent bracket who donates to a charity effectively pays only 65 cents for each dollar she gives because giving a dollar reduces her tax bill by 35 cents (35 percent of the deductible one-dollar donation). That lower after-tax price of giving provides the taxpayer with an incentive to give more to charitable causes than she would in the absence of the deduction and consequent tax savings. The same outcome obtains for other itemizable spending; for example, people may buy more or better housing because the deductibility of mortgage interest and property taxes reduces their after-tax costs. Limiting the value of deductions to 28 percent would increase the after-tax cost of charitable giving and other itemizable expenses for high-income taxpayers and would therefore reduce the amount of those activities they would undertake.
The 2005 President's Advisory Panel on Federal Tax Reform10 proposed replacing itemized deductions with a 15 percent credit on most itemizable expenditures. That change would give all taxpayers the same tax savings for a given deductible expenditure, severing the connection between tax rates and the value of deductions. It would recognize the public value attached to particular expenditures but remove those expenditures from the determination of ability-to-pay.
The proposal would limit the value of deductions for about one-third of taxpayers in the top income quintile in 2012, raising their taxes by an average of almost $1,200. About 85 percent of taxpayers in the top 1 percent would pay more tax, an average increase of more than $15,000.
Footnote
Distribution tables
Limit the value of itemized deductions to 28 percent
2012 versus current law by cash income
2012 versus current law by cash income percentiles
2012 versus current policy by cash income
2012 versus current policy by cash income percentiles
Additional Resources
Tax Policy Briefing Book: Income Tax Issues: What is the difference between tax deductions and tax credits?
Budget Options, Congressional Budget Office, February 2007, p 270
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