The vast majority of the attention given to the Bush tax cuts has been focused on changes in top marginal rates, the treatment of capital gains income, and the estate tax. But another, less visible component of those cuts has been gradually making itemized deductions more unfair and expensive over the last five years. Since the vast majority of states offering itemized deductions base their rules on what is done at the federal level, this change has also resulted in state governments offering an ever-growing, regressive tax cut that they clearly cannot afford.
In an attempt to encourage states to reverse the effects of this costly and inequitable development, the Institute on Taxation and Economic Policy (ITEP) this week released a new report, "Writing Off" Tax Giveaways, that examines five options for reforming state itemized deductions in order to reduce their cost and regressivity, with an eye toward helping states balance their budgets.
Thirty-one states and the District of Columbia currently allow itemized deductions. The remaining states either lack an income tax entirely, or have simply chosen not to make itemized deductions a part of their income tax — as Rhode Island decided to do just this year. In 2010, for the first time in two decades, twenty-six states plus DC will not limit these deductions for their wealthiest residents in any way, due to the federal government's repeal of the "Pease" phase-out (so named for its original Congressional sponsor). This is an unfortunate development as itemized deductions, even with the Pease phase-out, were already most generous to the nation's wealthiest families.
"Writing Off" Tax Giveaways examines five specific reform options for each of the thirty-one states offering itemized deductions (state-specific results are available in the appendix of the report or in these convenient, state-specific fact sheets).
The most comprehensive option considered in the report is the complete repeal of itemized deductions, accompanied by a substantial increase in the standard deduction. By pairing these two tax changes, only a very small minority of taxpayers in each state would face a tax increase under this option, while a much larger share would actually see their taxes reduced overall. This option would raise substantial revenue with which to help states balance their budgets.
Another reform option examined by the report would place a cap on the total value of itemized deductions. Vermont and New York already do this with some of their deductions, while Hawaii legislators attempted to enact a comprehensive cap earlier this year, only to be thwarted by Governor Linda Lingle's veto. This proposal would increase taxes on only those few wealthy taxpayers currently claiming itemized deductions in excess of $40,000 per year (or $20,000 for single taxpayers).
Converting itemized deductions into a credit, as has been done in Wisconsin and Utah, is also analyzed by the report. This option would reduce the "upside down" nature of itemized deductions by preventing wealthier taxpayers in states levying a graduated rate income tax from receiving more benefit per dollar of deduction than lower- and middle-income taxpayers. Like outright repeal, this proposal would raise significant revenue, and would result in far more taxpayers seeing tax cuts than would see tax increases.
Finally, two options for phasing-out deductions for high-income earners are examined. One option simply reinstates the federal Pease phase-out, while another analyzes the effects of a modified phase-out design. These options would raise the least revenue of the five options examined, but should be most familiar to lawmakers because of their experience with the federal Pease provision.
Read the full report.