Wednesday, May 29, 2013
Jane G. Gravelle
Senior Specialist in Economic Policy
Analyst in Public Finance
The President and leading Members of Congress have indicated that income tax reform is a major policy objective. Some itemized deductions are visible candidates for “broadening the base” of the individual income tax and cutting back on tax expenditures and primarily consist of deductions for mortgage interest, state and local taxes, and charitable contributions. The benefits of itemized deductions are concentrated among higher-income individuals, and that is particularly the case for state and local income tax deductions and charitable deductions.
Proposals for addressing these provisions fall into two general classes. One approach could include repealing or restricting all itemized deductions. A different approach would consider each type of deduction and tailor a reform to the particular objectives and merits of the deductions, such as a lower ceiling on home mortgage interest deduction and a floor for charitable contributions.
This report analyzes various proposals to restrict itemized deductions—both across-the-board and individually tailored—using standard economic criteria of economic efficiency, distribution, simplicity, and estimated revenue effects. In particular, this report estimates each proposal’s potential to contribute to revenue-neutral reductions in income tax rates and the consequences for economic behavior. For an introduction to tax deductions, see CRS Report R42872, Tax Deductions for Individuals: A Summary, by Sean Lowry. For general tax data analysis on itemized tax deductions, see CRS Report R43012, Itemized Tax Deductions for Individuals: Data Analysis, by Sean Lowry.
Regardless of the class of reform undertaken, for a given revenue target, tax reform involves a trade-off between a broader base and lower income tax rates. One objective of lower rates is presumably to reduce the distortionary effects on labor supply and saving. The analysis in this report, however, shows that this trade off, with respect to effects on labor supply or saving, may be more apparent than real. Economic theory indicates that the tax rate that should determine the supply responses is not the statutory marginal tax rate but the effective marginal tax rate (EMTR). If part of the earnings of the last dollar is spent on tax exempt uses, then EMTRs are lower, and eliminating these deductions raises them.
It is possible for a revenue-neutral tax reform to have no effect on EMTRs, or even raise them, which, for some, may defeat the purpose of tax reform. Analysis in this report suggests that eliminating itemized deductions would increase the top EMTR by approximately 4½ percentage points but permit a statutory rate reduction in a distributionally and revenue-neutral change by about 5 percentage points. Thus, the net effect of this change is a reduction of ½ a percentage point (a tenth the size of the statutory reduction). Proposals with ceilings could easily raise EMTRs.
A traditional concern of tax expenditures is generally that they distort economic behavior. However, for each type of deduction there are also some justifications, although the magnitude may be in question. The provision that may have the most support from an economic efficiency standpoint is the deduction for charitable contributions.
Some types of tax reform may simplify the tax code, but others can make it more complex. In addition, transitional rules may be needed for the mortgage interest deduction to limit the impact on taxpayers with large mortgages and to soften the potential impact on the housing market.
Date of Report: May 21, 2013
Number of Pages: 50
Order Number: R43079
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