Capping Itemized Deductions to Pay for Rate Cuts

Both sides in this year’s presidential election campaign have a fair way to go to get real on the budget problem.  Democrats are making hay by attacking the only viable tool to bend the Medicare (and health care generally) cost curve.  And Republicans are promising very specific steps that would cut income taxes, while keeping their counsel on what they would do to offset the cost (not to mention actually increasing net revenues to reduce the deficit).

The tax issue came up again in the campaign debate this week.  President Obama challenged Governor Romney to specify how he would offset the cost of the tax rate cuts that he has proposed.  Governor Romney returned to a notion that he had floated earlier: a cap on the amount of itemized deductions that each taxpayer could claim.

Governor Romney described the idea this way:

And so, in terms of bringing down deductions, one way of doing that would be say everybody gets — I’ll pick a number — $25,000 of deductions and credits, and you can decide which ones to use. Your home mortgage interest deduction, charity, child tax credit, and so forth, you can use those as part of filling that bucket, if you will, of deductions.

There are a number of issues associated with this idea.  Some have been discussed fairly widely, while others have not.

The fundamental question, of course, is how much money such a cap could raise.  After the debate raised the issue, the non-partisan Tax Policy Center reported estimates (considering only itemized deductions; Governor Romney’s concept could extend to other tax preferences). Recall that the tax rate reductions that Governor Romney proposed would reduce revenues over the next ten years by about $5 trillion.  To take the extreme formulation of the cap concept, eliminating all itemized deductions for all taxpayers (which surely would violate both candidates’ pledges not to increase taxes for the “middle class,” even taking the tax rate cuts into account) would recapture about $2 trillion of that.  So a cap that actually allowed any continued deductions at all cannot possibly be the complete answer to paying for those $5 trillion worth of tax rate cuts.

But the cap approach could stay in the debate as a part of a package to offset the cost of any tax rate cuts, and so it is worth a closer look.

Obviously, the impact of the tax cap depends upon precisely how it is implemented.  The plan the Governor described (a cap at $25,000) would recover about $1.3 trillion of the $5 trillion cost of the tax rate cuts.  It would be relatively well targeted to upper-income taxpayers.  Half of the tax increase from the cap considered alone would come from the 1 percent of taxpayers with the highest incomes; almost 89 percent would come from the highest 20 percent.  Still, a very few taxpayers even in the lowest 20 percent ranked by income would hit the cap and lose deductions, and about 10 percent of taxpayers in the middle 20 percent of the population would be affected.  The calculations do not show whether any of those taxpayers would be worse off after both the rate cuts and the deduction cap; the answer to that question would depend on whether or not the “baseline” would include continuing the soon-to-expire 2001 and 2003 tax cuts.

One aspect of this potential cap on deductions has received very little attention, but could be important.  It relates to the likely reactions from different affected constituencies, some quite influential politically, if the cap idea is perceived to have legs (as some in Washington would put it).

Itemized deductions were on the table in the run-up to what became the Tax Reform Act of 1986.  In the end, even though it became law, the Tax Reform Act did very little with respect to itemized deductions.  (It did repeal the almost nuisance-level deduction for state sales taxes — although subsequently, states that had sales taxes but not income taxes have managed to obtain a provision to allow taxpayers with sales tax liability higher than state income tax liability to deduct the former rather than the latter.  It also increased the floor above which medical expenses could be deducted from 5 percent to 7.5 percent of adjusted gross income (AGI).)  The reason why so little was done was because of intense political opposition — not so much from individual taxpayers, but from the interests behind the deductions.

For one example, then-Senator Bill Bradley (D-NJ) proposed in 1982 in effect to convert the itemized deductions into tax credits at a flat rate that would be lower than the highest tax bracket rate.  (Specifically, itemizers could claim a “credit” equal to 14 percent of their itemizable expenses, whereas the top-bracket tax rate would be 30 percent.)  The Bradley proposal did not remove the itemizable status from state and local taxes (other than the sales tax). Still, Governor Mario Cuomo (D-NY) took vigorous issue with the idea.  He complained that the switch to the credit would so reduce the tax-reduction value of state taxes that governors would face enormous resistance to increasing taxes when necessary — or even maintaining the levels of taxes that they already collected.

Later, the final version of the Tax Reform Act made no change to the deductions for mortgage interest or charitable contributions. Still, housing and non-profit groups protested vigorously — simply on the ground that the reduction of tax rates, and thus of the value to the taxpayer of an extra dollar of itemized mortgage interest or gifts to charity, would inhibit purchases of housing or gifts to the university or the community hospital.  Those groups are highly influential.  Real estate is a major piece of every local economy — and as luck would have it, just about everybody lives at the local level.  And the heads of the universities and the hospitals and the arts institutions, not to mention the churches, are almost always the pillars of their communities — and people notice when the pillars begin to shake.  In the end in 1986 their complaints were overridden, but they significantly raised the decibel level of the debate in the closing weeks.

Those experiences are instructive as we consider the suggested itemized deduction cap.  Governor Romney’s premise is that the effect of his cap will be confined to upper-income taxpayers; and as noted above, the Tax Policy Center finds that it would achieve that goal fairly well.  But in so doing, it would offend the interests that opposed the 1986 Tax Reform Act — in significant part because the itemized deductions of upper-income taxpayers are unlike those of the typical taxpayer.

Here are some key facts.

In 2009 (the latest year for which data are available), the average itemizer with an income as low as between $100,000 and $200,000 claimed $28,999 of deductions.  (Taxpayers in this range ranked from about the 87.5 percentile to the 97.5 percentile of all tax returns arrayed by income, and earned roughly 24 percent of all income.)  So for essentially all taxpayers from that income level on up, a $25,000 itemized deduction cap would be an active part of their tax calculations.  And for the roughly 2.5 percent of all taxpayers above the $200,000 level, the cap would likely bind.  Taxpayers with incomes between $200,000 and $500,000 itemized an average of $51,124 of deductions.

And as suggested above, these upper-income taxpayers do not follow the typical “middle-class” pattern of deductions. For example, consider the mortgage interest deduction, the bread-and-butter tax preference of the quintessential American family.  Some people extend what they see in their neighborhoods to a hasty conclusion that the very wealthy reap a bonanza from massive mortgage interest deductions.  But think about it.  The spectacularly wealthy don’t take out spectacularly large mortgages to buy their estates (nor do banks typically write spectacularly large mortgages in the first place); rather, they pay cash from their spectacular wealth (or at least make spectacularly large down payments).

For reference, those taxpayers with incomes between $100,000 and $200,000 are about 85 percent likely to itemize, and of those who itemize, about 86 percent itemize mortgage interest in an average amount of $13,207.  By way of contrast, those taxpayers with incomes between $2 million and $5 million are almost 98 percent likely to itemize, but of those who do, only about 60 percent itemize mortgage interest, in an average amount of only $33,912 — greater than in the $100,000-to-$200,000 income range, but nowhere near the proportional difference in their income.  The very highest income category reported by the IRS, those with incomes of over $10 million, are 98.5 percent likely to itemize, but of those who do, only 46 percent itemize mortgage interest, in an average amount of only $36,286 — again, greater, but by far less than the proportional increase in incomes.

These amounts of mortgage interest deductions are, of course, averages.  The economist I most admired, the late Arthur Okun, used to caution people about averages with a story about a six-foot-tall economist who drowned in a stream that was an average of three feet deep.  There surely are people in these relatively thin populations of very large incomes who depart markedly from the average.  But that having been said, aggregate tax results are driven by the averages.  And furthermore, only the all-knowing Almighty can impose rules that are perfectly tuned to the uniqueness of every individual; the tax code falls somewhat short of that standard.

Bear with me for two more statistical exercises.  So first, if very-high-income people do not itemize very much by way of mortgage interest, where do their deductions come from?  Look at state and local taxes.

Of the itemizers in our tax-cap-marginal income group with between $100,000 and $200,000 of income, 99.91 percent (roughly) itemized at least some state and local taxes, in an average amount of $11,105.  Of the itemizers with incomes from $2 million to $5 million, 99.76 percent itemized state and local taxes, but in a much larger average amount of $229,700.  The top category with incomes over $10 million were 99.62 percent likely to itemize state and local taxes, but in the striking average amount of $2,000,233.

Now consider the other big itemized-deduction category of charitable contributions.  Of those with between $100,000 and $200,000 of income, about 90 percent claimed deductions for gifts to charity, in an average amount of $3,904.  Of the itemizers with incomes from $2 million to $5 million, almost 96 percent claimed charitable contributions, but again in a much larger average amount of $98,152.  And almost 98 percent of the top category with incomes over $10 million itemized charitable gifts, in an average amount of $1,745,161.

So put all of this number soup together in one bowl.  What will happen if a $25,000 cap on itemized deductions shows up, still breathing, on the budget negotiating table?

First of all, the home real estate, state and local government, and non-profit communities will think immediately and instinctively about the high-income population.  Those are the taxpayers for whom the cap systematically will apply.  But furthermore, that is where the money is — not only in terms of tax collections for both the federal and state / local governments, but also for purchases of homes, and for substantial charitable gifts.  How those interests perceive the impact of the deduction-cap proposal on the behavior of upper-income taxpayers will determine what they have to say in the debate.  And they will speak loudly, and they will be heard.

At this week’s debate, Governor Romney implicitly chose to speak to those for whom the itemized deduction cap would bind.  “You can decide which [deductions] to use.  Your home mortgage interest deduction, charity, child tax credit, and so forth, you can use those as part of filling that bucket, if you will, of deductions.”  That may be true on paper, but in terms of economic incentives and behavior, the impact will be quite different.  To the extent that itemized deductions are incentives — to the extent that the charitable contributions deduction is intended to encourage people to give, for example — the deduction cap will defeat their purpose entirely.

The deduction for state and local taxes is central — and consider that it is a mandatory expense, in contrast to mortgage interest (for a taxpayer who can choose to rent) and charitable contributions (for a taxpayer who can keep all of his money for himself).  So before he makes any other decisions, a $3 million-of-income taxpayer who contemplates giving $98,152 to charity will know that his $25,000 itemized deduction “bucket” already runneth over with $229,700 of state and local taxes.  That taxpayer will know that he can write down on his capped Form 1040 Schedule A that he is itemizing the maximum $25,000 of charitable contributions and $0 of state and local taxes.  But he also will understand, if he can comprehend the marginal analysis, that he saved not a dime because of all of the money he gave to charity.

The same will be true if that taxpayer contemplates borrowing money to buy a home.  And when the taxpayer thinks about the money he pays in state and local taxes, he will realize that he could pocket dollar-for-dollar any amount that he could convince his governor or mayor to cut from his tax bill.

So what will happen if the $25,000 cap hits the streets as a realistic policy option?

First of all, Governor Andrew Cuomo (D-NY; the more things change, the more they remain the same) — and all of his Democratic and Republican colleagues in state and local government — will protest that they will be assaulted by the heart of their tax bases, who will not only resist any necessary tax increases, but also likely will demand tax reductions that will only exacerbate budget shortfalls across the country.  Meanwhile, the real estate industry will point to the weakness of construction activity and the many underwater mortgages today, and will predict yet another housing crash if the most-affluent potential buyers perceive no marginal tax relief from taking on a bigger mortgage.  And finally, the distinguished boards of every university, symphony, ballet company, art museum and hospital, and most men (and women) of the cloth will preach impending disaster if their most generous benefactors will receive no tax benefit in return for their generosity.

Will those claims have merit? The case is arguable both ways. Charity and housing construction did not end in 1986, though the proposed deduction cap would have an impact in theory that would be far more severe.  But the likelihood and intensity of this debate are not arguable; they are certain. And based on the 1986 experience, that debate will have an impact on the outcome.

Advocates of deduction caps (and the like) have argued in the past that those devices have the merit of sparing the Congress from making difficult choices among state and local taxes, mortgage interest, charitable contributions, and other deductions. In a very limited sense, that argument is true.  But sometimes the Congress has to make the tough decisions to get both good and politically acceptable public policy.  This is one of those instances.  The nation needs real tax reform to square the circle between higher revenues and economic efficiency; but the itemized deductions cap is likely to be only a small contributor to that solution.

  1. Dave Thomas said:

    Anything to starve the beast that is the bloated, corrupt federal government.

  2. Tim Clark said:

    Terrific analysis, Joe!

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