President Barack Obama’s first budget plan projects a deficit of $1.75 trillion this year, a tax increase of nearly $1 trillion over the next ten years, and a rise in spending of more than 1.5 percent of GDP. But it is not just the magnitude of the numbers that matter—or the irony that this fiscal plan doused in red ink is said to herald a “new era of responsibility”—it is the specific consequences of the policies on the U.S. economy and on our society.

Of all of the tax proposals in the Obama administration’s budget, the one receiving the most attention may be the proposal to limit the benefit for high-income households from itemized deductions such as charitable donations, mortgage interest, and state and local taxes. This is the type of “base-broadening” that could be envisioned as part of fundamental reform of our complicated and distortionary tax system if married with lower marginal rates. But the Obama budget proposal came as a surprise since it is not part of an overall effort to cut rates and simplify the tax code. Rather, it is a stand-alone tax increase.

Capping the charitable donation deduction makes state and local taxes more burdensome, increases the cost of housing, and reduces the incentive to donate to charities.

It works like this: Under current law, paying a dollar in mortgage interest or in state and local taxes or giving a dollar to charity reduces your tax bill by your marginal tax rate. For a high-income taxpayer, a $100 charitable contribution results in a tax deduction that lowers his income tax by $35, resulting in a $65 net cost to that taxpayer. President Obama proposed limiting the benefit of all itemized deductions for individuals with incomes above $200,000 and married couples with incomes above $250,000. Beginning in 2011, those taxpayers could get at most a $28 federal tax benefit for a $100 charitable contribution rather than the $39.60 deduction that would apply under current law when the Bush tax cuts expire.

This proposal fits nicely in the overall context of the Obama budget proposal by bringing nearly $16 billion of new tax revenue in 2012 (rising to $27 billion in 2019) to help pay for a portion of the administration’s spending binge, and by achieving a more progressive tax system, since the tax increase applies only to higher-income households. However, capping the deduction makes state and local taxes more burdensome, increases the cost of housing, and reduces the incentive to donate to charities. These impacts affect high-income taxpayers everywhere, but the impact is likely the greatest in Democratic-leaning states since these tend to have the highest state tax rates, the most expensive houses, and the greatest concentrations of upper-income households that make large donations to charity.

The tax hit on charitable donations is sizeable—a 20 percent increase in the cost of giving to charity for high income taxpayers. According to projections from the nonpartisan Tax Policy Center, $50 billion in charitable donations will be made by taxpayers that would be affected by the Obama proposal if it was enacted. Recent economic research finds that among higher-income taxpayers, a 1 percent increase in the after-tax cost of a charitable donation reduces contributions by about 1 percent. This means that the Obama proposal would reduce charitable donations by roughly $10 billion in 2011 and by $125 billion over ten years. To put that in context, $10 billion is the combined annual private support to The United Way, Salvation Army, American Cancer Society, Food for the Poor, YMCA of the USA, and Feed the Children.

Moreover, the Obama administration's proposal is not just a tax increase on itemized deductions, but also a tax increase on work. By reducing the tax benefit of certain types of consumption, as Obama is proposing, a larger share of a worker’s income will be paid in taxes. 

Among higher-income taxpayers, a 1 percent increase in the after-tax cost of a charitable donation reduces contributions by about 1 percent.

Of course, this would not be the first time in recent years that the tax incentive for charitable contributions has been reduced. President Bush reduced the top marginal tax rate from 39.6 percent to 35 percent, thereby raising the net cost of a $100 donation from $60.40 to $65, a nearly 8 percent increase in the cost of giving. But that policy had offsetting effects. While the net cost of charitable donations went up, lower overall taxes meant that Americans had more after-tax income with which to make charitable donations. The lower tax rates would also be expected to encourage work, innovation, and entrepreneurship and thereby lead to increased future incomes. Under Obama’s proposal all of the impacts on charitable giving are negative—reduced incentive to give to charity, lower disposable income, and a bigger drag on economic growth.

Not surprisingly, the Obama administration’s tax proposal has received a cool reception on Capitol Hill. While this initial congressional angst might make charities feel optimistic, they should remain aware that there will certainly be a need to collect more revenues from taxpayers eventually. In Washington, bad ideas sometimes go away but they rarely die.

We hope that a future proposal by President Obama will be a fundamental reconsideration of our tax system, not just a revenue grab. The goal of broad tax reform would be to make the system simpler, to reduce the negative impacts of high marginal tax rates, and to encourage savings and investment while maintaining the already substantial progressivity in the tax code. This sort of reform could boost long-term U.S. growth—and take charitable donations to a higher level as well. Future proposals from the administration should move toward broad tax reform rather than try to squeeze more money out of the same broken system.

Alex M. Brill is a research fellow at the American Enterprise Institute and previously served as chief economist and policy director to the House Ways and Means Committee. Phillip Swagel served as assistant secretary for economic policy at the Treasury Department from December 2006 to January 2009.

FURTHER READING: Alex Brill, Arthur Brooks, and Alan Viard discussed the Obama tax plan in The Washington Post. Viard recently released Tax Policy Lessons from the 2000s, bringing together the most up-to-date research available on tax policy with analysis by America’s leading economists.

Image by Darren Wamboldt/The Bergman Group.