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||2017||2018||2019||2020||2021||2022||2023||2024||2025||2026||2017-2021||2017-2026|
|Change in Revenues|
|Limit the tax benefits of itemized deductions to 28 percent of their total value||7.2||14.9||15.8||16.6||17.4||18.2||19.0||19.9||20.7||21.6||71.9||171.5|
|Limit the tax value of itemized deductions to 6 percent of AGI||5.2||10.6||11.2||11.6||11.9||12.5||13.2||13.8||14.3||14.9||50.5||119.2|
|Eliminate all itemized deductions||93.2||193.8||206.4||216.7||227.0||237.0||247.5||258.7||270.4||281.1||937.1||2,231.8|
Source: Staff of the Joint Committee on Taxation.
This option would take effect in January 2017.
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 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. Most of those tax savings constitute a "tax expenditure" by the federal government. (Tax expenditures resemble federal spending in that they provide 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 loan amounts in excess of $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. That reduction can reduce a taxpayer's itemized deductions by up to 80 percent (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 to broadly restrict the total amount of itemized deductions that taxpayers can take:
- The first alternative would limit the tax benefits of itemized deductions to 28 percent of the deductions' total value while removing the Pease limitation. 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 $172 billion from 2017 through 2026.
- The second alternative would limit the tax benefits of itemized deductions to 6 percent of a taxpayer's AGI while removing the Pease limitation. 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 were 6 percent or less of their AGI would be unaffected by the change. This approach would raise revenues by $119 billion from 2017 through 2026, according to JCT's estimates.
- The third alternative would eliminate all itemized deductions. As a result, all taxpayers who currently itemize deductions would have to claim the standard deduction, which generally would be of less value to them. Taxpayers who would have claimed the standard deduction under current law would be unaffected by the change. JCT estimates that this approach would raise revenues by $2.2 trillion from 2017 through 2026.
A major argument for reducing or eliminating itemized deductions is that their availability encourages taxpayers to spend more on deductible activities in order to receive the tax benefits those activities provide; that tendency can lead to an inefficient allocation of economic resources. For example, the mortgage interest deduction distorts the housing market, prompting people to take out larger mortgages and buy more expensive houses, and pushing up home prices. People therefore invest less in other assets than they would if all investments were treated equally. Reducing the tax benefits of itemized deductions would diminish taxpayers' incentive to spend more on specified goods or activities than they would under current law. That would improve the allocation of resources because taxpayers would make spending decisions based on the benefit they derive from the specified goods or activities, rather than based on tax considerations. Doing less of some 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 of tax-deductible spending in the latter category is contributions to charitable organizations.
Each of the three alternatives in this option would reduce the incentives for taxpayers to spend on tax-deductible items 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 from as high as 39.6 percent to 28 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-deductible items. In contrast, limiting the tax value of itemized deductions to 6 percent of AGI 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 that threshold. Eliminating every itemized deduction would remove the tax incentives for all taxpayers to spend more on deductible items. Among all itemizers, limiting the tax subsidy to 28 percent would have the smallest effect on incentives to spend on tax-deductible items. Eliminating itemized deductions would have the largest effect on incentives.
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 6). 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.
Another argument for reducing or eliminating itemized deductions is that higher-income taxpayers benefit more from those deductions than do taxpayers with lower income because people with higher income typically have more deductions and because the per-dollar tax benefit of those deductions depends on a taxpayer's marginal tax rate, which rises with income. In calendar year 2013, CBO estimates, more than 80 percent of the tax expenditures resulting from the three largest itemized deductions—for state and local taxes, mortgage interest, and charitable contributions—accrued to households with income in the highest quintile (or one-fifth) of the population (with 30 percent going to households in the top 1 percent of the population). In 2013, the tax benefit of those three deductions equaled less than 0.05 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. Hence, reducing or eliminating them would increase the progressivity of the tax code. Capping the tax value of deductions at 28 percent would increase taxes primarily on taxpayers in the top 10 percent of the before-tax household-income distribution. In contrast, limiting the tax value of deductions to 6 percent of AGI or eliminating itemized deductions altogether 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.
The three variants would affect the complexity of the tax code in different ways. Eliminating itemized deductions would simplify the tax code. Taxpayers would no longer have to keep records of their deductible expenses or enumerate them on the tax form. In contrast, the other two alternatives would increase the complexity of the tax code to some extent. 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 essentially have to compute their taxes twice—once with their itemized deductions and once without those deductions—to determine whether the tax benefits of their itemized deductions exceeded the relevant threshold.
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, casualty and theft losses, or state and local taxes 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 against these alternatives is that reducing the value of itemized deductions would disrupt many existing financial arrangements, especially in the housing market. Many homeowners have purchased homes under the assumption that they would be able to deduct the interest on their mortgages and their property taxes. Reducing the value of those deductions would make it more difficult for some homeowners to meet their obligations. And such a change would also reduce the amount new homebuyers would be willing to pay, which would lower the prices of homes, on average. Lower housing prices would create further stress on the finances of existing owners.
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 2017 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. That proposal, which also retains the Pease limitation, would increase revenues by $542 billion from 2017 to 2026, according to JCT's estimates.