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Why Limiting Itemized Deductions (Still) Makes Sense

January 23rd, 2012 . by economistmom

limit-itemized-deductions-table-taxnotes-dlrogers-0123121

It’s a proposal that has come up over and over again in President Obama’s budget, and one that I hope will come up yet again.  In my column in today’s Tax Notes (subscription-only access here), I remind readers that this is a great idea whose time has (been overdue to) come: the proposal to limit itemized deductions–to either 28 percent (the President’s version) or 15 percent (the more aggressive version suggested by CBO’s budget options volume). I like it because it’s a proposal to raise a lot of revenue (and reduce the deficit), yet by reducing a large tax expenditure in a progressive way.

How much revenue would the proposal likely raise?  A lot.  I refer to CBO estimates:

The CBO estimates 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.

A lot of people get confused about this proposal, thinking that it eliminates the tax subsidy for households above the limiting bracket, but it does far from that.  It only limits the size of the subsidy so that the richest households don’t get the biggest subsidies per level of the subsidized activities (in both percentage terms and dollar terms), which makes the proposal a very “progressive” way to reduce a (huge) tax expenditure.  Right now the subsidy is a regressive one, because for any given level of subsidized activity, higher-bracket households get the biggest subsidies.  I constructed the table above to make clearer how that upside-down subsidy works, and how the limit would level at least part of it–the upper end–out.  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.  Ideally, I 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.  As I point out in my column:

Assuming that the goal is in fact to encourage and steer resources to the activities that are subsidized, the case for the effectiveness of this particular form of subsidy depends on how much more responsive higher-income households are to the [price incentive] effect than are lower-income households. This is an empirical question that’s difficult to answer from the data because high-income households with the biggest price subsidies are also those with the greatest income capacity (who might donate the most to charity or buy the largest houses regardless of the itemized deduction). And while the evidence that’s out there shows some price responsiveness, it’s not always clear that it’s the type of responsiveness we would want. A larger charitable deduction might encourage more reported giving without increasing real giving, and a larger mortgage interest deduction might encourage people to buy larger houses rather than helping them to buy any house. And all of the deductions may merely reward behavior that would have taken place anyway.

So I put out my column as my strong endorsement of this proposal. The bottom line is that this is a way to raise substantial revenue from only higher-income households and would actually improve economic efficiency (reduce the distortions caused by the tax subsidies).  It’s a base-broadening, revenue-raising, deficit-reducing, yet government-shrinking proposal.  It’s consistent with the fiscal policy goals of both Democrats and Republicans.  It would also be a piece of cake to implement, unlike other base-broadening proposals that have similar economic advantages.  Why don’t we just do it, finally?!!

19 Responses to “Why Limiting Itemized Deductions (Still) Makes Sense”

  1. comment number 1 by: AMTbuff

    Large medical expenses and casualty losses are much more fairly treated as reduction of taxable income. The proposal treats a family with $200,000 income and $100,000 of unreimbursed medical expenses as being better off than a family with $100,000 income and zero medical expenses. That violates any common sense notion of horizontal equity.

    Calling this medical expense deduction a tax expenditure is even more wrong. It’s quite obviously a horizontal equity adjustment, not a form of spending.

  2. comment number 2 by: Vivian Darkbloom

    AMT,

    The issue of “horizontal equity” is a difficult one. Is there general agreement as to what that means?

    To follow your example, suppose that the family with $200,000 income and $100,000 of unreimbursed medical expenses (or casualty losses) incurred those expenses because that family did not have medical insurance or homeowner insurance, respectively. Should the family with $200,000 of income and which had zero such expenses because they put out for medical insurance and/or homeowner insurance subsidize them through the tax system? Does this result in “horizontal equity” in your view?

  3. comment number 3 by: Arne

    AMT provides another good reason for universal healthcare. We don’t really want to provide an incentive to spend more on healthcare in the same way we want to provide an incentive for getting into home ownership or for investing in business.

  4. comment number 4 by: Patrick R. Sullivan

    ‘I like it because it’s a proposal to raise a lot of revenue (and reduce the deficit)….’

    Whoa! Watch out for that planted axiom.

  5. comment number 5 by: Vivian Darkbloom

    “AMT provides another good reason for universal healthcare. We don’t really want to provide an incentive to spend more on healthcare in the same way we want to provide an incentive for getting into home ownership or for investing in business.”

    Quite the opposite, if what you mean by “universal health care” is Medicare for all. People who get health care at government expense have even more incentive to spend on healthcare than if they have to pay for it themselves or through private insurance. By your logic, we would spend less on housing if the government were to just provide everyone with a place to live.

    Perhaps the government should get completely out of the business of subsidizing health care for anyone who can afford to purchase insurance. AMT has focused on the itemized deduction, but the JCT estimates the 5 year cost of that to be about $78 billion. The 5 year cost through subsidies provided via employer-provided insurance and the self-employment deduction is about $790 billion over the same period.

    It makes little sense to address “itemized deductions” for health care without considering above-the-line exclusions and adjustments for the same.

  6. comment number 6 by: Arne

    “By your logic, we would spend less on housing if the government were to just provide everyone with a place to live.”

    Not the same context. A progressive tax system is justifed by the fact that someone who has more can afford more. The healthcare deduction is there because we understand that if circumstances (catastrophic healthcare expenses) have already taken, then having made more does not mean you have more.

    The fact that it provides an incentive to spend more is an undesirable side effect of healthcare deductablility. Medicare for all has an undesirable side effect wrt spending incentives (as well as some positive spending effects), but it would eliminate the clash with the justification for progressivity.

  7. comment number 7 by: SteveinCH

    By all means! Let’s make the tax code even more complex and preserve the mess that deductions have made of the code. Why you ask?

    Because the code is insufficiently progressive. Never mind that the income tax code is already massively progressive. Never mind that most of America thinks that FICA taxes are some sort of prepayment for something, said prepayment being the worst investment any wealthy person will ever make. For all the noise about housing, housing through the bubble was a better investment for people in the top income quintile than SS will be fore them.

    We once again recognize that the highest value in the pantheon is (more) progressivity. How much more? Well, I’m sure the folks in favor of it will let us know when we get there.

  8. comment number 8 by: SteveinCH

    By all means! Let’s make the tax code even more complex and preserve the mess that deductions have made of the code. Why you ask?

    Because the code is insufficiently progressive. Never mind that the income tax code is already massively progressive. Never mind that most of America thinks that FICA taxes are some sort of prepayment for something, said prepayment being the worst investment any wealthy person will ever make. For all the noise about housing, housing through the bubble was a better investment for people in the top income quintile than SS will be fore them.

    We once again recognize that the highest value in the pantheon is (more) progressivity. How much more? Well, I’m sure the folks in favor of it will let us know when we get there.

  9. comment number 9 by: Vivian Darkbloom

    “Not the same context. A progressive tax system is justifed by the fact that someone who has more can afford more.”

    Arne, first off, the progressivity of our tax code has little, if anything, to do with how much we spend on healthcare or how the tax code incentivizes or disincentivizes spending on health care. Progressivity, as such, is a separate issue.

    I’m sure you are going to respond that this is “not the same context”, but it strikes me that if this is your only justification for “progressivity”, I might be justified in walking into a bank, preferably a very large one, and demanding they turn over money to me. Or, go over to my neighbor’s house, preferably a very rich one, and help myself to whatever it is will take to make us “equal”. After all, they can “afford it”.

    I think you need to refine your justification somewhat. If Mr. A makes a choice to work twice as hard as Mr. B (who values more his leisure) and earns twice as much, should Mr. B be entitled to 25 percent of Mr. A’s income? And, in the following year, if Mr. B wins the lottery and earns twice as much as Mr. A that he should share that in equal proportion? Does your view take into account any difference between those two situations?

    I’ve written here before that in my observation the primary difference between “progressives” and “conservatives” is that progressives will almost always argue that Mr. A just got lucky (and Mr. B got unlucky in year 1). Conservatives will argue that Mr. A worked harder and therefore deserves his compensation (and perhaps use the same argument for Mr. B’s lottery winnings, too). The truth, however, is that for some folks it *is* luck (Mr. B) and for some it *is* hard work which is a reflection of personal preference (Mr. A) ; but, for most of us it is a combination of the two.

    The tax system should (and to an inadequate degree now does) recognize these factors; however, our tax system should be designed to incentivize and reward work and saving in equal proportion and, yes, contain a certain degree of progressivity in order to account for that unquantifiable element of random statistical chance that some folks with more mystical minds call “luck”.

    And, aside from these rather philosophical issues, the system devised should actually work without too much friction on the economy as a whole. I’ve never heard anyone argue that the amount of resources spent on administering a tax system is a societal good in and of itself, aside, except perhaps from the narrow, self-serving view of, say, an accountant or a tax lawyer or a government bureaucrat.

  10. comment number 10 by: dave

    factcheck: is the U.S. personal income tax regressive?

    Heck, no. Those with income over $1 million already pay at a rate three and a half times that of those with income between $50,000 and $75,000.

    In fact, over HALF the income taxes in this country are paid by the top 5% of earners.

    If you want progessivity, you’ve ALREADY got it.

    To demand more is just,.. piggy.

    The president has called for fairness in taxation. I agree. Implement a fundamentally flat tax with a marginal rate decrease of not more than 25% (of that rate) below $50,000. And no special interest deductions or credits, such as the president requested increasing in his SOTU address.

  11. comment number 11 by: Arne

    “I think you need to refine your justification somewhat.”
    I was sloppy, but it should be clear I was just talking about one justifying factor and the fact that that factor gets turned on its head when someone actually has to pay for catastrpohic healthcare expenses. Also sloppy because it applies even when taxation is regressive.
    “progressives will almost always argue that Mr. A just got lucky”
    I think this is similarly sloppy. ‘Just got lucky’ is not the same as luck played a part is his success.

  12. comment number 12 by: AMTbuff

    Limiting deductions would appear to be an essential precursor to raising marginal rates to the sky. We can’t have taxpayers getting back 90 cents on the dollar on a deductible expenditure just because the marginal tax rate is 90%.

  13. comment number 13 by: Vivian Darkbloom

    “I was sloppy…”

    Well, Arne, it happens to the best of us.

    “I was just talking about one justifying factor and the fact that that factor gets turned on its head when someone actually has to pay for catastrpohic healthcare expenses. ”

    As I hinted in my reply to AMT’s comment, this is not always a matter of “bad luck”. Is failing to purchase health insurance a matter of “bad luck” or is it for many a personal choice? And, what has it got to do with progressive taxation, as I indicated in my earlier post? On the spending side, we should help those who really can’t buy insurance buy that insurance. This has, nothing, per se, to do with whether on the taxing side or system should be “progressive”.

    “I think this is similarly sloppy. ‘Just got lucky’ is not the same as luck played a part is his success.”

    I trust you are assigning that sloppiness to those who make the argument and not to me. If the latter, go back and read this (and everything that followed:

    “The truth, however, is that for some folks it *is* luck (Mr. B) and for some it *is* hard work which is a reflection of personal preference (Mr. A) ; but, for most of us it is a combination of the two.”

    That was *my* justification for a progressive tax system, provided, at the same time, the system adequately rewards incentivizes work and saving.

  14. comment number 14 by: Arne

    What you say that “progressives will almost always argue” sounds like the kind of straw man that conservative politicians and pundits prefer to fight. If you are seeing people actually say that, then perhaps the “slightly
    left of center” at Angry Bear is more accurate than I thought.

  15. comment number 15 by: vivian lewis

    Filthy Lucre
    Is money earned on money saved or invested supposed to be taxed or is this double-taxation? That is an old philosophical question. Most religions do not approve of money making money which is considered usury.

    The monotheistic religions all consider the return from investment as less wholesome than the return from work.

    Islam prohibits ”riba”, defined as interest, based on a revelation to Mohamed written in the Koran.

    St. Thomas Aquinas, the medieval saint and thinker, famously called interest ”filthy lucre”.

    Judaism prohibits charging interest on loans to other Jews. But in the Middle Ages the sages allowed Jews to charge interest on loans to non-Jews, mainly because it was hard for Jews to survive otherwise.

    So Pres. Obama’s proposal to tax unearned income topping $1 mn per taxpayer per year is firmly within the Judeo-Christian canon. And if it was sheltered by being retained at the firm to cut taxes on its execs as was done by Bain Capital (not alone in that form of perq for execs, who can then pay at the capital gains rate) it is even more vulnerable.

    Of course the Church of Jesus Christ of the Latter-Day Saints is not wholly Judeo-Christian and I have a suspicion that its tenets do not condemn usury or money making money.

    However, I think it will be tough for Mitt Romney to defend a tax proposal from which he will be a victim with a 30% bite vs a current 14%.

    The defenders of lower taxes on savings or investment argue that the money has already been taxed as earnings before it was saved or invested, which in the case of Bain & Co is not even true. Then too companies do pay taxes before sharing out dividends, although they can usually deduct interest they pay on bonds or savings.

    But all the same, the fruits of saving or investing have not been taxed as steeply as what people earn by the sweat of their brow.

    More for paid subscribers follows from Israel, Finland, and Singapore and a few other places where we have ill-got gains from filthy lucre like India, Germany, South Africa, and Brazil.

    Vivian Lewis, who trumps you as an economist grandmother. ed, http://www.global-investing.com

    Full content is available to subscribers only. Subscribe now.

  16. comment number 16 by: TStockmann

    Since we’re picking and choosing deductions, I’d argue that all state and local taxes should remain/become deductible. Philosophically, I think it’s nice and federal to give the smaller political grouping the first bite at the apple, and tax on the net that is left. I’d point out that state and local expenditures tend to substitute or complement federal programs, so the deduction has a higher marginal return to the center than, say, the egregious charity deduction, where the goals can be irrelevant - or even opposed - to the national government’s mission.

  17. comment number 17 by: Vivian Darkbloom

    Here’s an interesting case study of a person with a 102 percent “effective tax rate”.

    http://www.nytimes.com/2012/02/04/business/at-102-his-tax-rate-takes-the-cake-common-sense.html?_r=1&hp

    This supports arguments that

    1. Use of taxable income to determine one’s “effective tax rate” makes no sense;

    2. Eliminating itemized deductions might make sense (even more so than selectively limiting them).

  18. comment number 18 by: AMTbuff

    VD, most deductions are intended to improve horizontal equity. For example, someone who makes $1000 but pays $5000 in state income tax has similar spendable income to someone who makes $95000 but pays no state income tax. Disallowing the state income tax deduction would result in unequal treatment of taxpayers who have equal spendable income.

    Obviously a gross income tax is simpler and its marginal rate can be lower, depending on the size of any exemptions. Its weak point is horizontal equity, and that is a fundamental necessity for any tax code that hopes to be perceived as fair.

  19. comment number 19 by: Vivian Darkbloom

    AMTbuff,

    One would need, of course, to first define what “horizontal equity” properly is. Let’s take your example (but add a couple of zeros to $1,000):

    It appears that you are comparing someone who lives in, say, New York state, rather than Nevada. If they are both resident in NY, then, by this standard, they should be horizontally equal without the federal tax deduction.

    In that case (which you are free to rebut):

    1. It is quite possible, even likely, that the pre-tax income of the New Yorker is higher precisely because he pays higher state income taxes;

    2. It is possible that the person in NY gets more from government services (reduced in-state tuition, etc) than a person who pays no state income taxes. Does this enter at all into the “horizontal equity” equation?;

    3. If the resident with the higher state income taxes is not getting his money’s worth, would it not be more appropriate for him to:

    a. Resist those higher taxes or demand better services; or
    b. Move to a state with lower taxes?

    If state taxes are not deductible, the market will sort all of this “inequality” out without the tax code unnecessarily mucking it up through itemized (and many other) deductions. We can then be free to concentrate on tax rates solely, rather than making the code much more complicated in the hopeless cause of making everyone perfectly “equal”, horizontally, vertically, perpendicularly or whatever.

    You have chosen the easiest case (deductibility of state income taxes) , albeit one that is defective for many reasons, some of which are stated above.

    Also, the deduction for state income taxes is a federal subsidy that encourages states to rely on income taxes rather than other taxes and/or user fees. From 1986 to 2004 there was no deduction for state sales taxes, even though those taxes often simply replace the income tax as a means of raising revenue. Now, there is a partial deduction which, if you are concerned with “horizontal equity” is extremely imprecise. This is set to expire next year unless extended.

    I’m surprised that you would support such a notion is completely counter to your otherwise sensible calls to make the tax code simpler.

    You stated “most deductions are intended to improve horizontal equity”. Perhaps the “intended part is meant as an admission that intent and result are often widely divergent; however, I would be interested in your take on how the mortgage interest deduction, the real estate tax deduction and the charitable deduction are all intended to, and actually result in, “horizontal equity” however you define that. (We’ve already covered the medical cost deduction). Is the mortgage interest deduction, for example, intended to make people “horizontally equal” or is it a politically expedient subsidy of homeowners and the banking and realty industries?

    It is precisely these sort of deductions that are “intended” to make people “equal” which actually make the tax code unncessarily complicated and which produce the conditions under which some people are able to be more equal than others. It kind of reminds me of what Orwell said.