Tax deductions for individuals are an important part of federal income taxes and most states’ income taxes.
In a previous post, I outlined four desiderata for a reformed tax system: responsive, fair, simple and transparent, and enforceable. In this post, I aim to convince you that tax deductions for individuals are neither fair nor simple and transparent. (Important: tax deductions for businesses are different and not discussed in this post.)
How Deductions Work
A deduction is pretty much what its name says: when you compute your tax, you deduct the amount of the deduction from your actual income, getting your taxable income. The tax code allows deductions for various items like interest paid on a home mortgage, property taxes paid, charitable contributions, state and local income taxes, and many other things. There are restrictions and other complexities on all of these deductions, but we’ll ignore them for now.
Let’s look at a simplified example. Suppose your income is $100,000 and you have a $5,000 deduction, your taxable income becomes $95,000. In the simplest situation, you then look up your taxable income in the tax rate chart and, voila, you have your tax. Here’s the tax rate chart for 2018 Federal taxes for a married couple filing jointly:
|Up to $19,050||10% of taxable income|
|Over $19,050 but not over $77,400||$1,905 plus 12% of the excess over $19,050|
|Over $77,400 but not over $165,000||$8,907 plus 22% of the excess over $77,400|
|Over $165,000 but not over $315,000||$28,179 plus 24% of the excess over $165,000|
|Over $315,000 but not over $400,000||$64,179 plus 32% of the excess over $315,000|
|Over $400,000 but not over $600,000||$91,379 plus 35% of the excess over $400,000|
|Over $600,000||$161,379 plus 37% of the excess over $600,000|
(Note: This table is in a form that is easier to work with than the basic table in an earlier post.) Looking $95,000 up in the table yields taxes of $12,779. Without that deduction, taxes would have been $13,879. The way to think about this is that the deduction saved the taxpayer the marginal tax rate applied to the deduction: 22% of $5,000 or $1,100. (If the deduction is large enough to lower the taxable income into a lower tax bracket, the idea is similar but the calculation is slightly more complicated.)
Deductions Are Regressive
Now, let’s take the same $5,000 deduction against a $700,000 income. The marginal rate for this taxpayer is 37%, so the same $5,000 deduction saves this taxpayer $1,850 instead of the $1,100 saved by the lower-earning taxpayer.
To think about fairness, let’s suppose that the taxpayer takes a $5,000 deduction for home mortgage interest. Effectively, it costs the first taxpayer, the one earning $100,000, $3,900 to pay their $5,000 mortgage interest (the $5,000 less the $1,100 tax savings from the deduction); it only costs the much wealthier taxpayer $3,150 to pay their $5,000 mortgage interest.
In both cases, the deduction reduced the homeowner’s taxes, thus subsidizing the purchase of the home. We could debate whether the government should subsidize home purchases at all, but why should the government provide a larger subsidy to the wealthier of the two homeowners for the exact same mortgage interest?
Likewise, suppose that these two taxpayers both give a $100 contribution to their favorite charity. Charitable contributions are deductible, so the government is subsidizing these contributions. It costs the less wealthy taxpayer $78 to contribute $100 to his favorite charity, but it costs the much wealthier taxpayer only $63 to make the same contribution.
This is one of the reasons that deductions are regressive: The same deduction is worth more to wealthier taxpayers than to less wealthy taxpayers.
Repeal of the Pease Limitation
In fact, legislators recognized that high-income taxpayers could reduce their tax obligations through large deductions. In 2013, the Pease limitation (named after the late Congressman Donald Pease) was introduced. It reduced the value of deductions for high-income earners (over $305,050 for married filers). But, the Pease limitation was repealed in the 2017 “tax reform”, thus restoring the full regressive benefit of deductions. (Believe it or not, there is another layer of complexity, the alternative minimum tax, which can, under certain circumstances, also reduce the benefit of certain deductions for middle- and high-income earners.)
Standard Deduction and Itemized Deductions
All taxpayers are entitled to the standard deduction. Starting in 2018, the standard deduction is $24,000 for a married couple filing jointly. Like all deductions, the standard deduction is regressive: The higher your marginal tax rate, the more the deduction is worth to you.
Alternatively, a taxpayer can choose to itemize deductions, i.e., list specific deductions on IRS Schedule A. Common examples of itemized deductions are home mortgage interest, charitable contributions, state and local income taxes, property taxes, and large (over 7.5% of earnings) medical expenses.
Taxpayers whose itemized deductions sum to less than the standard deduction, choose the standard deduction. Although taxpayers taking the standard deduction lose out on the subsidies provided by itemized deductions, their tax preparation is simplified.
Itemized Deductions Subsidize Higher Earners
The subsidies provided by the tax savings from itemized deductions flow predominantly to the wealthier among us, those for whom itemizing deductions is worthwhile. In 2014, only 30% of taxpayers itemized deductions (as reported by the Tax Policy Center). More than 80% of taxpayers earning over $100,000 itemized deductions, while only 7% earning $30,000 or less did so. The 70% who do not itemize deductions get no subsidy of home mortgages, charitable contributions, state and local income taxes, property taxes, or large medical expenses.
Why don’t more people itemize deductions so that they can get the subsidies?The answer is two-fold:
- Itemized deductions subsidize economic activity that only the middle-class and above can afford to participate in.
- Poorer people can’t possibly spend enough on subsidized activities to have enough deductions to make itemizing worthwhile.
These data about itemizing deductions are from 2014, before the standard deduction was raised and the Pease limitation dropped in the 2017 “tax reform” bill. As a result of raising the standard deduction in 2018 and beyond, it is expected that even fewer taxpayers will find it worthwhile to itemize and for those that do itemize, Pease limitations no longer reduce the value of those deductions. Both changes will further skew the benefits of itemized deductions toward higher earners.
Some deductions are available even to people who do not itemize deductions. These deductions are called above-the-line deductions. The 2017 version of IRS Form 1040 lists a dozen such deductions. Although such deductions are available to people who don’t have enough deductions to itemize, most of them are for activities that poorer people can’t afford, e.g., contributing to an IRA for retirement savings; contributing to a health savings account (requires having a high-deductible medical insurance policy); paying self-employment tax; paying self-employed health insurance premiums; and, expenses of moving more than 50 miles for a new job.
Lack of Transparency
As we’ve seen, about 70% of taxpayers (and likely to increase) are unaffected by itemized deductions. Most people, therefore, are probably unaware of how deductions work and how they benefit higher earners. So, when a politician talks about a 37% tax rate on someone earning, say, a million dollars, it is easy to think that that person is paying $370,000 in taxes. In fact, that is only the marginal rate and deductions can substantially reduce taxable income and hence the effective tax rate paid.
Moreover, because deductions are part of a complex system to which most people are not exposed, it is easy for politicians to provide tax benefits that most voters don’t understand. I would imagine that few lower-income voters understand that the government is subsidizing home ownership for their wealthier neighbors through the mortgage interest and property tax deductions, and retirement through tax-deductible IRAs.
Rules, Rules, Rules
The rules surrounding tax deductions are voluminous, complicated, and ever-changing. There have been attempts to reign in some deductions through mechanisms like the Pease limitation, the alternative minimum tax, and restrictions on specific deductions. For example, arbitrarily large amounts of mortgage interest used to be deductible; then it was limited to interest on up to a total of a million dollars in mortgages; the 2017 “tax reform” lowers this to $750,000. IRS Publication 936 for tax year 2017, which explains the rules for mortgage interest deduction, is 17 pages long. IRS Publication 960, Tax Benefits for Education, is 87 pages long.
The complexity of these various deductions is mind-boggling. Even the instructions for the one-page Schedule A form used to report itemized deductions runs 18 pages!
Deductions are Big Dollars
Does any of this really matter? Well, yes. In May 2013, the Congressional Budget Office (CBO) analyzed the effect of various tax breaks on Federal tax revenues. Their report and supporting data are available as a CBO publication. For fiscal year 2013, the state and local taxes, mortgage interest, and charitable contribution deductions yielded taxpayers $186 billion in subsidies, amounting to 1.1% of the country’s gross domestic product.
Deductions Mostly Benefit High Earners
This is a lot of money being used to subsidize certain activities. Who is getting the benefit of these subsidies? To get at this question, the CBO report partitions people into quintiles as follows: Rank households according to their before-tax income, then divide the households into five quintiles, each containing a fifth of the total number. So, the lowest quintile contains, for example, the 20% of households with the lowest before-tax income, and the highest quintile contains the 20% of households with the highest before-tax income.
As the CBO report explains, “the benefits of itemized deductions rise sharply with income in 2013, ranging from less than 0.1 percent of after-tax income for households in the lowest quintile to 0.4 percent for households in the middle quintile to 2.5 percent for households in the highest income quintile”. So, the highest-earning 20% of households get 25 times more benefit from these deductions, as a proportion of their after-tax income, than the benefit that the lowest-earning 20% of households get.
Viewed another way, the CBO reports that households in the top quintile get 80% of the benefit of state and local taxes deduction, 73% of the benefit of the mortgage interest deduction, and 84% of the benefit of the charitable contribution deduction; households in the lowest quintile get no benefits from these deductions, while households in the second quintile get less than 2%. And within the highest quintile, the benefits are strongly skewed toward households in the top 1% of incomes. For example, 30% of the benefit of the state and local tax deduction goes to households in the top 1% of incomes.
Bottom line: Deductions help high earners the most, by far!
Unfair But Popular
Despite being unfairly skewed to benefit high earners, tax deductions and other tax breaks are popular with politically powerful middle- and upper-income earners. For example, when President Obama tried to curtail 529 Education Savings plans, the reaction from both citizens and the financial services industry was swift and intense, and he backed off. This, despite the fact that according to the Government Accountability Office, less than 3 percent of of families saved in 529 plans (or, the similar Coverdell plan) and families who use these vehicles have 25 times the median assets of those without such plans.
Likewise, the home mortgage interest deduction (and other tax breaks for homeowners) are strongly defended by the construction and realty industries, and by the middle-class people who benefit from them. It is surprising, in fact, that even the small constraints introduced in the “tax reform” act on the mortgage interest and property tax deductions were able to be enacted.
I hope that I’ve been able to give you enough detail so that you can understand why deductions are both unfair and complex. More detailed data are available in the CBO report on both deductions and other tax breaks. I will discuss the effects of the other major tax breaks in separate posts. You can imagine where this is headed: with one exception, all of the major tax breaks benefit primarily the highest-earners among us. Stay tuned.