Limit the Value of Itemized Deductions to the 28 Percent Bracket
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 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.
The president proposes limiting the value of itemized deductions to no more than 28 percent starting in 2012, but only for taxpayers with income above specified thresholds. That limit would increase taxes for taxpayers whose tax rate exceeds 28 percent and reduce for them the incentives that the deductions provide. In 2012, those affected would include all taxpayers in the 35 percent tax bracket and some of those in the 33 percent bracket. Starting 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 $321 billion through 2021.*
This change would interact with Pease (the limitation on itemized deductions). 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 for charitable giving at all. 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.
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 for about one-ninth of taxpayers in the top income quintile in 2012, raising their taxes by an average of about $5,000. Just over 80 percent of taxpayers in the top 1 percent would pay more tax, an average increase of more than $11,000. In 2013, after the 2010 tax act expires and top tax rates rise, about one-eighth of taxpayers in the top quintile would pay an average of about $9,000 more tax compared with current law and over 80 percent of those in the top 1 percent would pay an average of more than $20,000 additional tax.
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
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, Budget Options: Volume 2, August 2009, p. 192.
*The estimated revenue gain assumes that the 2001–03 tax cuts are extended for couples with income below $250,000 ($200,000 for singles, both 2009 values indexed for inflation) but allowed to expire for higher-income taxpayers.
**See Report of the President’s Advisory Panel on Federal Tax Reform, November 2005.