Limit the Value of Itemized Deductions
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
|(Billions of dollars)||2014||2015||2016||2017||2018||2019||2020||2021||2022||2023||2014-2018||2014-2023|
|Change in Revenues|
|Limit the tax benefits of itemized deductions to 28 percent of their total value||6||12||13||13||14||14||15||15||16||17||58||135|
|Limit the tax value of itemized deductions to 6 percent of AGI||6||11||9||8||7||7||6||6||6||6||40||71|
|Limit itemized deductions to $500,000 for joint filers ($250,000 for all others)||9||17||16||15||15||15||15||15||15||15||72||146|
Source: Staff of the Joint Committee on Taxation.
Notes: This option would take effect in January 2014.
AGI = adjusted gross income.
When preparing their income tax returns, taxpayers may either choose the standard deduction—which is a flat dollar amount—or choose to itemize and deduct certain expenses, such as state and local taxes, mortgage interest, charitable contributions, and some medical expenses. Taxpayers benefit from itemizing when the value of their deductions exceeds the amount of the standard deduction. The fact that those expenses are deductible reduces the cost of incurring them; so, in effect, the itemized deductions serve as subsidies for undertaking deductible activities. The tax savings from itemized deductions, and thus the amount of the subsidies, generally depend on a taxpayer’s marginal tax rate (the percentage of an additional dollar of income from labor or capital that is paid in taxes). For instance, $10,000 in deductions reduces tax liability by $1,500 for someone in the 15 percent tax bracket and by $2,800 for someone in the 28 percent tax bracket. Those tax savings constitute a “tax expenditure” by the federal government. (Tax expenditures resemble federal spending by providing financial assistance for specific activities, entities, or groups of people.)
The tax code imposes some limits on the amount of itemized deductions that taxpayers can claim. For some types of expenses (such as medical expenses), only the amount that exceeds a certain percentage of the taxpayer’s adjusted gross income (AGI) can be deducted. (AGI includes income from all sources not specifically excluded by the tax code, minus certain deductions.) Moreover, taxpayers cannot deduct home mortgage interest on loans above $1.1 million. In addition, the total value of certain itemized deductions is reduced by 3 percent of the amount by which a taxpayer’s AGI exceeds a specified threshold. The maximum limit is equal to 80 percent of itemized deductions (that is, taxpayers retain no less than 20 percent of their deductions). That limit, originally proposed by Congressman Donald Pease, is often called the Pease limitation.
This option considers three alternative approaches that would replace the Pease limitation with broader restrictions on the total amount of itemized deductions that taxpayers are allowed to take:
- The first alternative would limit the tax benefits of itemized deductions to 28 percent of the deductions’ total value. As a result, taxpayers in tax brackets with statutory rates above 28 percent would receive less benefit from itemized deductions than under current law, whereas taxpayers in tax brackets with statutory rates that are equal to or less than 28 percent would be unaffected by the change. The staff of the Joint Committee on Taxation (JCT) estimates that this approach would increase revenues by $135 billion from 2014 through 2023.
- The second alternative would limit the tax benefits of itemized deductions to 6 percent of a taxpayer’s AGI. As a result, taxpayers whose savings from itemized deductions exceeded 6 percent of their AGI would receive less benefit from itemized deductions than under current law, whereas taxpayers whose savings from itemized deductions was 6 percent or less of their AGI would be unaffected by the change. This approach would raise revenues by $71 billion from 2014 through 2023, according to JCT’s estimates.
- The third alternative would limit itemized deductions to $500,000 for married taxpayers who file joint returns and $250,000 for other taxpayers, with those thresholds adjusted, or indexed, for inflation. As a result, taxpayers whose itemized deductions exceeded $500,000 or $250,000, depending on their filing status, would receive less benefit from itemized deductions than under current law, whereas taxpayers whose itemized deductions were equal to or less than those thresholds would be unaffected by the change. JCT estimates that this approach would raise revenues by $146 billion from 2014 through 2023.
The primary argument for the option is that the availability of itemized deductions encourages taxpayers to spend more on deductible activities in order to receive the tax benefits those activities provide, and that tendency can lead to an inefficient allocation of economic resources. For example, the mortgage interest deduction prompts people to take out larger mortgages and buy more expensive houses, and therefore to invest less in other assets, than they would if all investments were treated equally. Reducing the tax benefits of itemized deductions would reduce taxpayers’ incentive to spend more on goods or activities than they ordinarily would just because those activities receive favored treatment in the tax code. Doing less of certain activities for which expenses can be deducted under current law—in particular, activities that primarily benefit the taxpayers undertaking the activities—would improve the allocation of resources. However, doing less of other activities for which expenses can be deducted—in particular, those activities that offer widespread benefits—could worsen the allocation of resources. An oft-cited example in the latter category is the work of charitable organizations.
If policymakers wanted to maintain the current tax subsidy for certain activities while reducing the tax subsidy for others, they could adopt one of the approaches described in this option but exempt certain deductions entirely from the restrictions or limit certain deductions in a less constraining way. For example, policymakers could limit most itemized deductions in one of the ways offered above but allow taxpayers to fully deduct at their marginal tax rates any charitable contributions that are greater than some specified percentage of AGI (see Option 7). Imposing a floor on the amount of charitable contributions that could be deducted would reduce the tax expenditure for such contributions while continuing to encourage additional contributions by taxpayers who would give charities the threshold amount anyway.
Each of the three alternatives in this option would reduce the incentives for taxpayers to spend more on goods or activities that can be deducted, but in different ways and to different degrees. Limiting the tax benefit of deductions to 28 percent of their total value would reduce the incentives created by the existing system only for taxpayers in rate brackets above 28 percent, who would see their subsidy rate fall to 28 percent from as high as 39.6 percent. Those taxpayers would continue to receive a tax benefit for each additional dollar they spent on tax-preferred items, but the amount of that benefit would be less than under current law. Other taxpayers would not experience any change in their incentives to spend money on tax-preferred items. In contrast, limiting the tax value of itemized deductions to 6 percent of AGI or capping deductions at fixed-dollar amounts would eliminate the tax incentives for some taxpayers to spend more on tax-preferred items because taxpayers would not receive any tax benefit for each additional dollar spent above those thresholds. Among all itemizers, limiting the tax subsidy to 28 percent would have the smallest effect on incentives to spend on tax-preferred items, the Congressional Budget Office estimates. Limiting the tax benefits of itemized deductions to 6 percent of a taxpayer’s AGI would have the largest effect on incentives.
Each variant would increase the tax burden more for higher-income taxpayers than for those with lower incomes because people with higher incomes typically have more deductions and because the per-dollar tax benefit of those deductions rises with income. Under current law, the tax benefit of the three largest itemized deductions—for state and local taxes, mortgage interest, and charitable contributions—equals 0.1 percent of after-tax income for households in the lowest income quintile, 0.4 percent for the middle quintile, 2.5 percent for the highest quintile, and 3.9 percent for the top percentile. Capping the tax value of deductions at 28 percent would increase taxes primarily on taxpayers in the top 10 percent of the pretax household income distribution. Limiting the amount of deductions to a fixed dollar amount would chiefly increase taxes on taxpayers in top percentile of the income distribution because only the highest-income taxpayers tend to have deductions over $250,000 (or $125,000 for taxpayers who do not file jointly). In contrast, limiting the tax value of deductions to 6 percent of AGI would, to some extent, increase taxes on taxpayers throughout the top half of the income distribution because even some taxpayers in the middle quintile have deductions that are a large share of their income.
An argument against any of the alternatives described in this option is that some deductions are intended to yield a measure of taxable income that more accurately reflects a person’s ability to pay taxes. For example, the deductions for payments of investment interest and unreimbursed employee business expenses allow people to subtract the costs of earning the income that is being taxed. And taxpayers with high medical expenses or casualty and theft losses have fewer resources than taxpayers with the same amount of income and smaller expenses or losses (all else being equal). Under this option, taxpayers subject to the limitations on deductions would not be able to fully subtract those expenses from their taxable income.
Another argument for not adopting any of the three alternatives is that they would increase the complexity of the tax code to some extent. Of the three approaches, the simplest would be to cap total itemized deductions at a flat dollar amount. In contrast, capping the tax benefit of itemized deductions—either at 28 percent of itemized deductions or at 6 percent of AGI—would require taxpayers to do more complicated calculations to determine their tax liability: They would have to compute their taxes using two different methods and then pay the higher of the two amounts.
Each of these approaches could be expanded by subjecting more tax provisions to the limits or by tightening the limits on itemized deductions described above. For example, the President’s budget for 2014 proposed that a 28 percent limit be applied not only to itemized deductions but also to a broader set of tax provisions, including the exclusion for interest earned on tax-exempt state and local bonds, employment-based health insurance paid for by employers or with before-tax employee dollars, and employee contributions to defined contribution retirement plans and individual retirement plans. Applying a 28 percent limit to all of the provisions specified in the President’s budget would increase revenues by more than $400 billion over the 2014–2023 period. Alternatively, adopting the third approach above but reducing the income thresholds to $100,000 for joint filers and $50,000 for other taxpayers would also raise more than $400 billion over that period.