April 17, 2014

The President's Proposal to Limit Itemized Deductions is Still a Great Idea

For the fourth time in four years, President Obama has tucked a little gem of a tax policy proposal into his budget: the proposal to limit the tax benefit of itemized deductions to 28 percent.  It’s a great idea because it would reduce a large tax subsidy (i.e., “tax expenditure”) for those who need it least, improve the economic efficiency of the tax code and raise revenues that could be used as part of a deficit-reduction package. Last year the Congressional Budget Office estimated the president's proposal would raise $293 billion over 10 years. A more ambitious version limiting itemized deductions to a 15 percent rate, as presented in the CBO's compendium of budget options, would raise $1.2 trillion over 10 years -- in other words, equivalent to trimming overall tax expenditures (which are over $1 trillion per year) by about 10 percent through that one policy change alone.

This year, however, the Obama Administration went bolder on their general theme of reducing tax expenditures for high-income households and proposed the 28 percent limit not only for itemized deductions but also for foreign-excluded income, tax-exempt interest, employer-sponsored health insurance, retirement contributions, and “selected” above-the-line deductions.  All these current tax preferences would be limited to that which a taxpayer in the 28 percent tax bracket could enjoy.  As a result, the Administration estimates the broader proposal would raise $584 billion over 10 years—about double the revenue raised from the itemized deduction proposal alone.

A lot of people get confused about the President’s proposal, thinking that it would eliminate the tax subsidy for households above the limiting bracket, but it does no such thing.  It would only limit the size of the subsidy so that the richest households don't get the biggest subsidies.  Right now the subsidy is a regressive one, because for any given level of subsidized activity, higher-bracket households get the biggest subsidies.

For example, if a high-income household in the 35 percent marginal tax rate bracket has $1000 worth of charitable contributions, they can deduct $350  -- $1000 times (.35) from their tax liability.  On the other hand, a household in the 28 percent bracket that donates the same amount to charity (and also claims itemized deductions) could only deduct $280 --  $1000 times (.28).

In this example, the President’s proposal to limit the rate for itemized deductions to 28 percent would level out the subsidy at the upper end.  The higher-income household’s subsidy would go down to $280, the same amount as the middle-income household’s subsidy.

These proposals would not get rid of the regressivity below the limiting bracket, however, which could only be achieved if we went all the way to converting the deduction to a (refundable) credit, where a certain dollar amount of the subsidized activity is directly subtracted from one’s tax liability (or added to one’s net refund).  Many economists concerned about the proliferation of “upside-down subsidies” in the tax code would like to see all deductions converted to credits, but limiting deductions to 28 or 15 percent is a good step along that policy path.

And to counter arguments that this would kill the economic activities currently subsidized by the (full) itemized deduction, well, the evidence is actually very inconclusive about how much this tax subsidy actually makes a difference in the level of the subsidized activities (charitable giving, borrowing for homeownership), because it is always difficult to distinguish between real behavioral responses versus tax-strategic ones.  Often these tax subsidies just reward behavior rather than influence it, or they encourage something that is not quite the lofty social goal that policymakers had in mind.  I discussed these issues in a recent column in Tax Notes (subscription-only access here).[1]

The bottom line is that the capping of itemized deductions to a middle-bracket rate (such as 28 percent) is a way to raise substantial revenue from only higher-income households and would actually improve economic efficiency by reducing the distortions caused by existing tax subsidies.  Reducing these kinds of tax expenditures actually reduces the size and scope of government in our economy.  Thus, it's a base-broadening, revenue-raising, deficit-reducing, yet government-shrinking proposal.  It's therefore consistent with the fiscal policy goals of both Democrats and Republicans.  The itemized deduction limit would also be a piece of cake to implement, easier than other base-broadening proposals (including the new proposal to limit the employer-provided health benefits exclusion) that have similar economic advantages but would require more fundamental changes to the definition of taxable income. So why don't we just do it, finally?!!

[1] Diane Lim Rogers, “Limiting Itemized Deductions Still Makes Sense,” Tax Notes, January 23, 2012, pp. 465-69.