While liberals and conservatives battle over the wisdom of the 2017 tax cuts, that law has quietly created an opportunity for a new reform that could please both flat-tax conservatives and tax-the-rich liberals.
For decades, many economists have argued that itemized tax deductions complicate the individual income tax code, overly benefit the rich, and distort economic decision-making. Yet the popularity of itemization has made eliminating these deductions politically perilous.
That popularity is now waning.
New data from the IRS shows that the 2017 Tax Cuts and Jobs Act (TCJA) has substantially weakened the reach of tax itemization. Lawmakers should finish the job by eliminating the itemization of tax deductions and applying those new tax revenues to better uses, such as extending the TCJA.
Before tax reform, 70% of tax filers took the standard deduction ($13,000 for a married couple) rather than itemize their deductions for expenses such as mortgage interest, charitable giving, state and local taxes paid, and extraordinary out-of-pocket health spending.
The TCJA nearly doubled the standard deduction to $24,000 for a married couple ($12,000 for individuals), while curtailing some of the itemized deductions. Specifically, the state and local tax (SALT) deduction was capped at $10,000, the mortgage interest deduction was reduced from covering $1 million in mortgage debt to $750,000 (with additional new restrictions), and the health expense deduction was pared back as well.
Importantly, the standard deduction will continue to rise annually with inflation, while the $10,000 SALT deduction cap will not. Also, the elimination of the $4,050-per-person tax exemption offset some of the family savings of the higher standard deduction.
As expected, the higher standard deduction combined with the new limitations on itemized deductions to considerably reduce the number of tax filers who itemize. New IRS data (prepared by The Wall Street Journal) show that 90% of tax filers took the standard deduction this past spring. Breaking that figure down, roughly 92% of filers earning under $100,000 took the standard deduction, as did 73% of those earning between $100,000 and $250,000 (up from 22% before reform). Filers in the $250,000 to $1 million income range saw standard deduction usage soar from 4% to roughly 45%.
Even among million-dollar earners, the use of the standard deduction tripled to 29%.
Overall, the percentage of filers taking the standard deduction is likely to rise from 90% to approximately 95% within a decade, as the rising standard deduction continues to outpace the frozen SALT deduction and the frozen mortgage interest deduction cap (assuming the 2017 tax law is not allowed to expire).
The collapse in tax itemization from 30% of tax filers to as few as 5% within a decade should significantly reduce the political roadblocks to eliminating itemization, particularly when the remaining itemizers are receiving fewer marginal savings over the standard deduction.
Shifting the remaining tax filers to the standard deduction has several advantages:
First, these benefits are extraordinarily tilted to the top earners—both because the remaining itemizers are disproportionately high-income, and because a filer in the 35% tax bracket will save nearly three times as much money from the same $1,000 deduction as a filer in the 12% bracket. Thus, the majority of mortgage interest deduction and SALT deduction savings continue to accrue to earners over $200,000. Among those who continued to deduct their mortgage interest in 2018, million-dollar-income families saved eight times as much money from that deduction as a typical family earning $85,000.
Tax reforms that reduce the tax burden for the wealthy are not problematic if they are part of an across-the-board tax rate reduction that benefits everyone and encourages productive behavior. Instead, many of these remaining tax deductions serve no legitimate economic purpose.
The mortgage interest deduction essentially subsidizes the purchase of large homes by upper-income families. Just 9% of homeowners earning under $100,000 take this deduction, saving an average of just $770 each. Nor is the housing market dependent on this deduction, as just 5% of annual new home mortgages exceed $500,000, which is where most mortgage interest deductions occur. The housing market would survive just fine without this deduction – just as the housing markets in Canada, the U.K., and elsewhere do.
Even the current, scaled-back SALT deduction serves no economic purpose. It essentially provides as much as a $10,000 bonus deduction to those with enough other deductions to approach or exceed the itemization threshold. It is not an issue of double taxation (different levels of government fund different services, and each have a tax claim), and SALT inexplicably allows high-income taxpayers to cut their federal taxes simply because they chose to live in a place with more generous state and local government services.
The charitable giving deduction has proven to be less tax-sensitive than TCJA critics feared, as last year’s steep decline in the number of itemizing taxpayers brought only an inflation-adjusted 1.1% decline in charitable giving by families and individuals. In 2018, the top 0.1% of earners received 35% of the benefits of this deduction, while the top five% of earners received 75%. The larger standard deduction should easily account for charitable giving for most families. And if eliminating this deduction proves infeasible, lawmakers could instead offer a universal credit (rather than deduction) for donations above a certain threshold (perhaps $1,000). This policy would likely increase charitable giving while reducing the revenue loss of this tax preference.
The lesser-used deduction for health expenses above 10% of income (up from 7.5%) has traditionally been concentrated among earners under $75,000, where the typical $10,000 deduction would save $1,200 in their current 12% tax bracket. However, the collapse of itemization among that income group shows the declining importance of this deduction. It could be replaced with a flat credit for catastrophic out-of-pocket expenses.
Eliminating itemized deductions could burden upper-income families initially, yet the cost would quickly diminish.
A married couple earning $250,000 that had recently purchased a home with the maximum interest-deductible mortgage, ($750,000), had the maximum SALT deduction, and also donated $6,000 annually to charity (rising with income) would see its taxes rise by $6,000 in the first year, declining to zero over 20 years (at which point they would have entered the standard deduction even under the current tax system)—a total cost of 1.0% of their overall income over that 20-year period. Instead assuming a family income as high as $600,000 gradually reduces the cost to 0.6% of income over the same 20-year period, with no cost thereafter.
If the family above had instead taken out a $1 million mortgage a few years ago (for which the TCJA grandfathers in the full interest deduction), the cost of moving to an immediate standard deduction rises by roughly 0.3% of income over the stated figures.
Yet for the larger portion of families who are already five-to-15 years into paying their mortgage (where the annual interest deduction is already much smaller), the long-term cost of moving to an immediate standard deduction falls by as much as 75% relative to a family in the first year of its mortgage.
This suggests that phasing out itemization over five-to-seven years would drastically reduce the new burden on those who recently bought expensive new homes under the expectation of a continued mortgage interest deduction. After that point, the natural wedge between the standard deduction and itemization begins to quickly fall, making the shift much more affordable.
Overall, Congressional Budget Office estimates show that eliminating itemized deductions would raise revenues by approximately $85 billion per year (assuming the TCJA is extended). This largely upper-income tax increase could be used to reduce tax rates, extend the TCJA, or contribute to the revenue portion of a deficit reduction “grand deal.”
Regardless of whether one believes the overall tax burden should be higher or lower, it is clear that income tax itemization is simply a poor use of a tax preference. Its rapidly declining usage provides a long-awaited opportunity to simplify and improve the tax code.
Brian Riedl is a senior fellow at the Manhattan Institute. Follow him on Twitter @Brian_Riedl.
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