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The Myth of the Limits on Itemized Deductions

Wednesday, January 9, 2013

Media misinformation is the real threat to charitable giving. For better or worse, the fiscal cliff deal doesn’t actually cap any itemized deductions.

As the fiscal cliff deal began to take shape at the end of December, media reports stated that the agreement would cap itemized deductions. In the days since the agreement was signed into law, some articles have continued to claim that it limits itemized deductions, including the charitable deduction, and therefore discourages charitable giving. But, it’s all a myth. For better or worse, the new law doesn’t actually cap any itemized deductions.

It’s easy to see why people might think otherwise. The new law brings back to life a provision — in effect from 1991 through 2009, but lapsed from 2010 through 2012 — that Congress calls the “overall limitation on itemized deductions.” But, the name is a misnomer, and not the only one in recent tax legislation. For nearly everyone who is subject to it, the resurrected provision has no economic link to itemized deductions and doesn’t change the tax savings from giving more to charity.

Here’s how the provision — which tax geeks call the Pease provision after its author, the late Congressman Donald Pease (D-Ohio) — normally works. Taxpayers with adjusted gross incomes above a threshold are taxed on an extra amount equal to 3 percent of the excess income over the threshold. Last week’s law sets the 2013 threshold at $300,000 for married couples. So, if a couple has $800,000 of adjusted gross income, Pease adds in an extra taxable amount of $15,000 (3 percent of the $500,000 excess income), on which the couple pays $5,940 of extra tax if they’re in the 39.6 percent bracket. 

What does this have to do with itemized deductions? Nothing, except for how it’s labeled. The way the $15,000 gets added to taxable income is by subtracting $15,000 from the itemized deductions that the couple would otherwise claim. If the couple has $100,000 of charitable contributions, mortgage interest, state and local taxes, and other itemized deductions, Pease reduces the allowable deduction to $85,000. Deducting $85,000 rather than $100,000 makes taxable income $15,000 higher. But, calling the $15,000 a reduction in itemized deductions, rather than some other kind of increase in taxable income, makes no economic difference. No matter how it’s labeled, the extra taxable amount doesn’t change the couple’s incentive, on the margin, to give to charity or increase other itemized deductions.

Contrary to the recent accounts, the new law actually increases incentives to give to charity.

The incentive effects can be clarified by walking through how Pease affects the couple’s tax savings from giving an extra $100 to charity. Without Pease, the extra giving would boost the couple’s deductions from $100,000 to $100,100, trimming $100 from taxable income and providing $39.60 of tax savings. With Pease, the extra giving boosts the couple’s deductions from $85,000 to $85,100, still trimming $100 from taxable income and still providing $39.60 of tax savings. Either way, the tax reward for giving is 39.6 percent.

Because the $15,000 amount doesn’t go up when the couple claims more deductions, Pease doesn’t change the tax savings from claiming additional deductions. The $15,000 amount does go up if the couple earns more adjusted gross income, so Pease does amplify the tax burden from earning additional income. The Pease provision is actually a stealth tax rate increase rather than a cap on itemized deductions.

There is one caveat, which applies to high-income taxpayers whose itemized deductions are extremely small relative to their incomes. If the aforementioned couple’s contributions, taxes, mortgage interest, and certain other deductions had been less than $18,750, then Pease would have used a different formula to compute the extra taxable amount — that formula actually would have reduced the couple’s incentive to claim additional deductions. But, high-income taxpayers with such small deductions are few and far between. And certainly no charity should rely on them for financial support — by definition, people with few itemized deductions aren’t big givers.

Contrary to the recent accounts, the new law actually increases incentives to give to charity. For high-income people, the rise in the top bracket boosts the tax reward for giving from 35 to 39.6 percent. Unfortunately, the bracket increase also boosts the tax reward for working less and saving less.

Pease doesn’t actually reduce the tax benefits of giving to charity. But, reports that mislead donors into believing otherwise could prompt some of them to reduce their contributions. That misinformation is the real threat to charitable giving.

Alan D. Viard is a resident scholar at the American Enterprise Institute.

FURTHER READING: Viard also writes “To Clinton, and Beyond!” “Passing Tax Reform: The Devil is in the Deductions,” and “Here’s a New Tax on Savings You Didn’t Know About.” Andrew G. Biggs says “All Tax Increases Are Not Created Equal.” James Pethokoukis asks “Is Tax Reform Being Oversold?

Image by Dianna Ingram / Bergman Group

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