The Myth Of The Limits On 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.

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.

Read More at The American . By Alan D. Viard.

Photo Credit: 401K 2012 (Creative Commons)