Capping the Benefit from Itemized Deductions

Revenue raiser in Obama budget proposal

One of the initiatives in the Obama administration's budget proposal for 2010 would place a limit on the tax benefit high-income taxpayers can obtain from itemized deductions. Congress has responded so far with little enthusiasm, but the idea doesn't appear to be dead, if only because alternative methods of closing the budget gap may end up being even more distasteful. We don't have legislative language for the proposal, but the staff of the Joint Committee on Taxation has published an explanation. This article discusses the proposal based on the JCT description. A companion article questions whether the part of the proposal relating to alternative minimum tax (AMT) is properly crafted.

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Itemized deductions

Taxpayers who choose to itemize instead of claiming the standard deduction are allowed various deductions, including (with various limitations) medical expenses, state and local taxes, home mortgage interest, and charitable contributions. These deductions reduce the amount of income that is treated as taxable income. Someone who would otherwise pay tax on $100,000 of income and claims $20,000 of itemized deductions will pay tax on $80,000.

The amount of tax savings produced by $100 of itemized deductions depends on the tax rate that would otherwise apply to this increment of income. This is not the same as the average rate of tax paid by that person, or the rate at which his employer withholds from his wages. It's the rate that applies to the last $100 of income, which is typically the highest rate of tax applied to the taxpayer. This is known as his tax bracket.

The tax benefit produced by an itemized deduction reduces the cost of making the payment that gave rise to the deduction. For example, if an itemizer in the 15% tax bracket donates $10,000 to charity, the deduction will produce tax savings of $1,500, and the net cost of making the deduction is $8,500. In effect, the federal government subsidizes the charitable giving of taxpayers who itemize. It also subsidizes their homeownership costs (property tax and home mortgage interest are allowed as deductions) and medical costs.

Because the size of the benefit from an itemized deduction depends on the individual's tax bracket, the government provides a more generous subsidy to taxpayers at higher income levels. If someone in the 28% bracket donates $10,000 to charity, for example, he receives $2,800 in tax savings, nearly double the $1,500 received by a donor in the 15% bracket. This feature of the income tax is so familiar that it rarely provokes comment, but it is arguably an anomaly that the federal government provides a more generous subsidy for charitable donations, homeownership costs and other expenses of high-income individuals than it does for taxpayers at lower income levels.

The proposal

The Obama administration has proposed a 28% cap on the tax benefit allowed for itemized deductions. This cap is particularly significant because Obama also proposes to permit the lower tax rates for high-income individuals established under George W. Bush to expire. The highest rate under current law is 35%, but rates of 36% and 39.6% would be revived.

Under the proposal, if someone has total itemized deductions of $30,000, all of which fall in the 36% bracket, the initial tax calculation would produce tax savings of $10,800, but this new rule would increase the tax by $2,400 so that the tax benefit of the deductions would be $8,400, or 28% of $30,000.

Objections

The most vocal objections to this proposal have come from charitable organizations expressing the concern that this change would result in reduced contributions. The proposal does not cap the amount that can be claimed as a deduction, so an individual who is currently able to claim a $1,000,000 deduction would still be able to claim the same amount. The tax benefit of claiming that deduction would be smaller, however, making the cost of the donation higher. Charities expressed similar concerns in connection with the Bush tax cuts, because the reduction in the top tax rate from 39.6% to 35% had the effect of increasing the after-tax cost of charitable giving.

Another possible objection relates to the nature of itemized deductions. Some of them, such as the deduction for investment interest expense, represent costs of earning income that may be taxed at rates above 28%. A mismatch between the tax rate applied to the income and the rate applied when deducting an expense incurred in earning it seems inappropriate. This issue could be resolved by carving certain deductions out before applying the 28% cap, but the published description of the proposal doesn't mention such a feature.

The drafters of the proposal included an explanation of how it would work under the alternative minimum tax (AMT). Their thinking on this point includes a logical error, as explained in this companion article.

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