Itemized Tax Deductions: Bad Idea to Limit Them without Examination

Now that the policy makers realize taxes are going to rise unless Congress acts in the next 50 days or so, there are lots in bad ideas out there. That is the usual course of events.

The goal of the liberals lead by a re-elected President is to increase taxes on the wealthy and about anything else that exudes of success.  For the last two years, at least, that has meant to let the 2001 tax rates for those with income over $200,000 go back into effect. Plus raise the rate on capital gains and a few other things such as attack corporate jets, oil companies and carried interests.

 I am not even going to debate the issue. The election is over and most in Washington accepts the notion that taxes-particularly for the upper income taxpayers- will increase. This tax raising mantra will not solve the deficit issue, it will not create any jobs and it will not foster economic growth.

This in not about economics, it is about politics. That does not mean to imply I support the current tax regime. Indeed, I believe the current system is almost irretrievably broken and must be viewed and reviewed in totality.  The revenue side is part of the equation but so is excessive regulation and federal spending.

However, there is one particular tax idea that I think is a bad one. It is limiting, capping or ad hoc reducing itemized deductions. It is a concept Mr. Obama included in his proposals last year. His proposal is a sneaky one and has to be read very carefully as is normally his mode of operation to chose winner and losers. Mr. Romney also mentioned this idea.

A bit of background is in order. 

Taxpayers may reduce their taxable income by subtracting either the appropriate standard deduction or specifically designated itemized deductions such as medical expenditures, state and local taxes, mortgage interest, and charitable contributions, Because deductions reduce taxable income, their effect on tax liability depends on the taxpayer’s tax bracket. For example itemized deductions of say, 20,000 for a person in the 35 percent bracket cut taxes by $7,000 for the taxpayer and lesser amounts for those in lower marginal brackets

Itemized deductions according to some are subsidizes for certain government sponsored objectives, such as charitable giving, investment in housing, and helping states and localities by reducing the net cost to taxpayers paying higher state and local income and property tax. Most itemizers are higher income taxpayers but not used just exclusively for the wealthy.

Needless to say, industries and organizations that benefit from the activity guard the itemized status with a fervent zeal but collectively  make a juicy target for elimination or curtailment as a way to raise revenue. That is the beauty of the collective cap to reduce their use and benefit. The deduction survives but has little use.  It is an easier political equation to curb them through a broad reduction of all deductions than to fight these powerful forces one by one.

Let’s look at the math more closely.

Assuming a taxpayer has $100,000 in itemized deductions and is the highest bracket. Under the current tax code, the itemized deductions will reduce federal tax liability by $35,000

If the so-called temporary Bush tax cuts of 2001 expire (yes they are still called temporary 12 years later), the same itemized deductions will reduce the tax liability 40,000 (assuming a 40 percent rate) Therefore, the higher the rate the more beneficial it is for the taxpayer to keep the itemized deductions.

If the deductions were capped, limited or subject to whatever device that can be invented, the net effect is to make the taxpayer shoulder a greater burden of these expenditures and increase the take for the government. 

It is for this last reason I think this idea is bad policy and portends future shenanigans by the government. If the choice is to reduce the itemized deductions or increase the rate, take the rate increase. There are always ways to generate deductions, although not as easy as it used to be.

Hmmm, seems like a strange position. Well yes and no. It would be far easier in the future to continue to whittle away at the deductions and increase the government’s tax take than it will be to continue to raise rates.  However, the worst of all possibilities can happen, losing deductions and rising rates. A no way out scenario.

 In addition, if the deductions do not have any merit and there are many that are questionable as there are for their sister “exclusions from income” then they should be examined. Ad hoc, backdoor tax raising is just wrong. In the end, the real issue is what is the level a taxpayer should pay. How much is enough? This principal applies to the one percent and the ninety nine percent.

From what I have heard, in spite of some recent attention, curbing the itemized deductions in a vacuum will be difficult but never rule out the ability of government to take a circular route. However, make no mistake, higher taxes are on the way. That is the result of the election.