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Friday, October 12, 2012
Proposals to limit itemized deductions
Tax reform in the 2012 election: proposals to limit or eliminate itemized deductions
Tax reform is one of the major issues in the upcoming Presidential election, fueled by the conflicting goals of reducing the deficit and promoting economic growth. One such reform, which has been advocated by both President Obama and Governor Romney, among others, is to impose limitations on itemized deductions. This article examines the current and historical treatment of itemized deductions, provides a recent breakdown of average itemized deductions based on AGI, and analyzes a number of specific proposals for limiting itemized deductions.
Background. For pre-2010 tax years, if an individual taxpayer's adjusted gross income (AGI) exceeded an “applicable amount” (in 2009, $166,800 or, for a married person filing separately, $83,400), the individual's otherwise allowable itemized deductions (with certain exclusions) had to be reduced by the lesser of:
... 80% of the amount of itemized deductions otherwise allowable for the tax year. (Code Sec. 68(a)(2))
The reduction in itemized deductions (the “Pease” limitation) didn't apply to the deduction for medical expenses, the deduction for investment interest, nonbusiness casualty and theft losses, and gambling losses. (Code Sec. 68(c))
This limitation was gradually phased out under the Bush-era tax cuts, leading to its disappearance in 2010, and has remained off the books since that time. In other words, for the 2010, 2011, and 2012 tax years, taxpayers can deduct the full amount of their itemized deductions.
Under the EGTRRA sunset, the “Pease” limitation returns for tax years after 2012. Thus, the limitations on itemized deductions in Code Sec. 68(a) through Code Sec. 68(d) are scheduled to return in 2013.
Statistics on itemized deductions. The following are individual taxpayers' average itemized deductions claimed (interest, charitable contributions, and total, taken from IRS's “Statistics of Income” Bulletin data for the 2010 tax year), based on AGI:
... AGI of $0—$15,000: $7,911 interest, $1,472 contributions, $15,752 total.
... AGI of $15,000—$30,000: $7,609 interest, $2,058 contributions, $15,013 total.
... AGI of $30,000—$50,000: $7,976 interest, $2,285 contributions, $15,904 total.
... AGI of $50,000—$100,000: $9,320 interest, $2,815 contributions, $19,392 total.
... AGI of $100,000—$200,000: $12,093 interest, $3,857 contributions, $27,489 total.
... AGI of $200,000—$250,000: $16,450 interest, $5,825 contributions, $40,315 total.
... AGI of $250,000 and up: $23,194 interest, $19,651 contributions, $90,969 total.
In general, and for obvious reasons, taxpayers with higher income tend to claim higher deductions. Thus, any sort of cap would have the greatest impact on high-income taxpayers.
On a dollar-for-dollar basis, deductions are also worth more to taxpayers who are subject to higher brackets. For instance, a dollar spent on mortgage interest by a taxpayer in the 35% bracket effectively costs that taxpayer 65¢ because of the corresponding deduction against income taxable at 35%. However, a dollar spent on mortgage interest by a taxpayer in the 10% bracket effectively costs that taxpayer 90¢.
Proposals. There have been several proposals to reduce or eliminate itemized tax deductions.
Republican Presidential nominee Mitt Romney (Gov. Romney) has informally proposed, as a possibility in his overall plan to broaden the tax base and reduce rates, capping income tax deductions. He initially mentioned a $17,000 cap (without specifying whether it would be for individual or married taxpayers), which he described as a “bucket” that taxpayers can “fill” however they please. However, during the first Presidential debate, he indicated a flexibility with the precise amount, saying that it could also be $25,000 or $50,000, and that deductions in excess of the cap would essentially “disappear for high-income people.”One of Gov. Romney's campaign advisors, Harvard economist and former chairman of the Council of Economic Advisers, Martin Feldstein, has advocated a cap on the total value of tax expenditures (i.e., tax reduction) to 2% of AGI. According to his estimates, in 2011, his cap would raise tax revenue by $278 billion, or a 30% increase of the total projected income tax revenue for that year. (See http://www.nytimes.com/2011/05/05/opinion/05feldstein.html)
President Obama has also repeatedly called for a cap on itemized deductions. For example, the Administration's 2013 proposal would limit the benefit to certain higher-income taxpayers from itemized deductions, AGI exclusions, and certain above-the-line deductions (including pretax employee contributions to defined contribution plans and contributions to traditional IRAs) to 28% of the amount of the deduction or exclusion. This would effectively reduce the tax benefit from such items for taxpayers who are subject to marginal rates above 28%.
Vice Presidential candidate Paul Ryan's “2010 Roadmap for America's Future” would have eliminated nearly all tax deductions and exclusions, and replaced them with increased standard deductions ($25,000 for marrieds filing jointly, $12,500 for single taxpayers). His more recent “Path to Prosperity” called for scaling back certain deductions and credits, but didn't specifically identify which.
The Fiscal Commission's proposal would have eliminated itemized deductions, so that all individuals would take standard deductions only. It also would have permanently repealed the Pease limitation and replaced certain favored deductions (i.e., mortgage interest and charitable giving) with nonrefundable credits.
The Simpson-Bowles plan contained two different individual income tax options. One option would eliminate nearly all tax expenditures and eliminate the phase-outs of itemized deductions. The second would restructure certain tax expenditures, including replacing the mortgage interest deduction with a 15% refundable credit, so that each retains approximately 80% of its current benefit. Each scenario would be accompanied with simplified and lower tax rates.
The Bipartisan Policy Center's Debt Reduction Task Force called for eliminating itemized deductions and the standard deduction, instead allowing all taxpayers to claim limited refundable credits for home mortgage interest and charitable contributions.
The Wyden-Coats “Bipartisan Tax Fairness and Simplification Act of 2011” would have repealed certain itemized deductions and tax credits, and increased the standard deduction ($30,000 for marrieds filing jointly, $15,000 for single taxpayers). However, it would have retained the deductions for mortgage interest and charitable contributions. The plan would also have repealed the limit on itemized deductions.