Limit the Value of Certain Tax Expenditures
Taxpayers may reduce their taxable income by excluding particular kinds of income from taxable income and 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 both exclusions and deductions reduce taxable income, their effect on tax liability depends on the taxpayer’s tax bracket. For example, exclusions or 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 some itemized deductions—such as the deduction for extraordinary medical expenses and, arguably, state and local income taxes—is that the deductible expenses reduce the taxpayer’s ability to pay and should therefore not count in taxable income. But itemized deductions also subsidize certain behaviors, such as charitable giving and investment in housing, and help states and localities by reducing the net cost to taxpayers of paying higher state and local income, property, and (in some states) sales taxes.
Reasons for excluding particular kinds of income from taxation are more uncertain. The exclusion of interest on state and municipal bonds subsidizes the cost of borrowing for governments issuing the bonds but more direct subsidies would make more sense. Employer-paid health insurance premiums, like many benefits received through employment, are excluded for primarily historical reasons, though they often make up a sizeable share of compensation. However, that exclusion, like the exclusion of contributions to retirement plans, does encourage people to get health insurance coverage or save for retirement. In none of those cases, however, is there a strong rationale for giving larger tax breaks to higher-income taxpayers.
The president proposes limiting the value of itemized deductions and specified exclusions to no more than 28 percent starting in 2013.* That limit would increase taxes for taxpayers whose tax rate exceeds 28 percent and reduce for them the incentives that the deductions provide. In 2013, the limitation would apply to taxpayers in the 36 percent and 39.6 percent brackets. The administration estimates that the proposal would increase revenues by about $580 billion through 2022.** This change would apply after Pease (the limitation on itemized deductions) and would therefore interact with it. The 28 percent cap on the value of deductions combined with Pease could 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.
By reducing the after-tax cost of allowed expenditures, itemized deductions encourage certain behavior. For example, a taxpayer in the 35 percent bracket effectively pays only 65 cents for each dollar she gives to qualified charities because giving a dollar reduces her tax bill by 35 cents (35 percent of the deductible one-dollar donation). Many studies find that this lower after-tax price of giving increases charitable giving, although the extent of the increase is uncertain. But the incentive varies considerably among taxpayers; taxpayers in the 35 percent bracket pay 65 cents for each dollar they give to charities, taxpayers in the 15 percent bracket pay 85 cents per dollar, and the 65 percent of taxpayers who claim the standard deduction receive no subsidy at all for charitable giving. Other itemized deductions have similar incentive effects. 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.
Exclusions can similarly affect taxpayer behavior by eliminating income tax on particular kinds of income. Investors will accept lower interest payments on tax-exempt municipal bonds or demand more tax-exempt employment benefits rather than taxable cash pay. The former shifts part of the cost of state and local government borrowing from citizens of those jurisdictions to taxpayers in general, while the latter encourages overconsumption of benefits excluded from tax. While both subsidizing those borrowing costs and encouraging workers to obtain particular benefits may have social value, doing so as we now do through the federal income tax gives the largest benefits to taxpayers with the highest income.
The 2005 President’s Advisory Panel on Federal Tax Reform** 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. Similar limitations applying to home mortgage interest and charitable contributions were included in the 2010 debt reduction plans of the President’s Fiscal Commission and the Bipartisan Policy Center.
The president’s proposal would limit the value of deductions and specific exclusions for about one-seventh of taxpayers in the top income quintile in 2013, raising their taxes by an average of more than $10,000, relative to current law. Nearly 85 percent of taxpayers in the top 1 percent would pay more tax, an average increase of about $24,000.
Limit the value of itemized deductions to 28 percent
2013 versus current law by cash income
2013 versus current law by cash income percentiles
2013 versus current policy by cash income
2013 versus current policy by cash income percentiles
Tax Policy Briefing Book: Income Tax Issues: What is the difference between tax deductions and tax credits?
President’s Advisory Panel on Federal Tax Reform, Final Report, November 2005.
“Limit the Tax Benefit of Itemized Deductions to 15 Percent,” Congressional Budget Office, Reducing the Deficit: Spending and Revenue Options, March 2011, p. 151.
* Without congressional action, lower rates (18 percent and 8 percent, respectively) would apply to assets held for more than five years. The budget proposal would repeal the lower rates on long-held assets.
**See Report of the President’s Advisory Panel on Federal Tax Reform, November 2005
***Taxpayers for whom the credit exceeds their tax before credits would get the full benefit only if the credit were fully refundable.