by Gene Steuerle

In his latest economic perspective column, Tax Notes economic consultant Gene Steuerle completes his two-part series on the problems with converting itemized deductions to credits.

Date: Apr. 28, 8-97

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Gene Steuerle is a senior fellow at the Urban Institute and an economic consultant to Tax Notes.

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THE PROBLEM WITH CONVERTING
ITEMIZED DEDUCTIONS TO CREDITS

LAST OF TWO PARTS: EXAMINING EACH ITEMIZED DEDUCTION

[1] Itemized deductions fall into six major categories: medical expenses, state and local taxes, charitable contributions, interest deductions, casualty and theft losses, and miscellaneous expenses mainly related to the generation of income. The proposal to convert itemized deductions to credits at a single rate of 15 percent would treat most or all of these items as expenses to be subsidized at the same rate. Reform, however, requires that each of these items be examined one at a time. In most, if not all, cases, a deduction seems to be the most appropriate adjustment -- if there is to be one at all.

[2] Begin with medical expenses. Some believe that one's ability to pay tax is equal to income less extraordinary expenses beyond one's control. The itemized deduction for medical expenses applies only to extraordinary expenses above 7.5 percent of adjusted gross income. Suppose at an extreme that someone paid $100,000 in expenses and earned $100,000 in income. The simple notion behind the itemized deduction is that the person then has no income left over with which to pay tax. A 15 percent credit still wouldn't give a person enough to pay tax at, say, a 28 percent rate.

[3] Now in practice the tax code subsidizes medical expenses in very uneven and inefficient ways. The principal source of subsidy is the exclusion for employer-provided health insurance, not the deduction. If one wants to address the major distortions caused by the tax system in the field of health care, it would be worthwhile to consider converting the latter, open-ended exclusion to a credit that is capped at some fixed dollar amount. Converting the deduction by itself to a credit, however, would hardly be compatible with an exclusion. In sum, there is a case here for a credit but mainly as a substitute for the exclusion of employer-provided expenses, not the itemized deduction. A better-designed credit, moreover, would be capped so as to subsidize the first dollars of insurance purchased, not the last dollars spent. Thus, an open-ended 15 percent credit would retain some of the problems of the existing exclusion.

[4] For state and local taxes, the case is again mixed. If one views state and local taxes as the cost of purchase of state and local services, then no deduction or credit is warranted. If these expenses are not for services received, then there is a perfectly valid case for thinking of one's ability to pay federal taxes as equal to income less state and local taxes paid. True, there is still income that escapes tax, but it is primarily the income received by the recipient of the state and local services, not the payer. Again, take the extreme case of someone subject to a state tax of 100 percent. Unless that person had assets, she would not have the ability to pay federal income tax if the federal rate was 28 percent and the subsidy rate was 15 percent.

[5] There are separate cases for both a floor and a ceiling on the deduction. A floor might be appropriate to deal with that portion of state and local taxes that for most taxpayers represents services received. A ceiling prevents the federal government from subsidizing all expanded state and local government activity at the margin, but still gives recognition to taxpayers who bear above-average costs. States, by the way, generally do not reciprocate and grant deductions for federal taxes paid. While the case for a deduction, therefore, is mixed, there seems to be no better -- and perhaps a worse -- case for a credit. If the goal is merely to cut back on the value of these deductions, there are better ways.

[6] Despite all these caveats, medical expenses and state and local taxes represent the two best cases for a credit relative to a deduction. The case gets progressively worse as we consider the remaining itemized deductions.

[7] For charitable contributions, a credit would subsidize all gifts at an approximately equal rate (ignoring the nontaxability of the credit). A deduction, on the other hand, represents an attempt both to subsidize giving and to adjust the measure of ability to pay for gifts given. Suppose a taxpayer makes $100,000 in income and gives away $25,000 to charity. Granting a deduction for the $25,000, roughly speaking, simply treats that taxpayer equal to one who makes $75,000 and gives nothing away to charity.

[8] Once again, there is income that escapes tax, but one might argue that it is the income of the ultimate beneficiary of the charitable services. The tax code in general has never decided on how to treat transfers consistently. Thus, in the case of the charitable deduction, one can make a strong case that a deduction would be entirely appropriate for a giver.

[9] As a matter of incentives, conversion of the deduction to a credit probably gives the government much less bang per dollar of revenue foregone. Empirical evidence indicates that eliminating the charitable deduction would have its greatest effect on higher-income taxpayers who appear more responsive to the incentives involved.

[10] Converting to a charitable credit presents a number of new problems. An effective deduction from the tax base also applies to the income received by nonprofit organizations and to the value of gifts of time made by individuals to charities. In the first case, a charity with an endowment of $100 earning $10 on that endowment is allowed to exclude that $10 from taxable income. Any move toward a credit, to be consistent, should deny an exclusion to the charity as well and somehow require nonprofit institutions to pay some tax, after credit, on their capital income. Otherwise endowed charities are preferred over those without endowments, making the tax system give preference to perpetual over temporary nonprofit institutions.

[11] In like manner, a low rate of credit favors earlier giving. Take, on the one hand, a taxpayer who gives away $100 today to a charity that saves the money for a year and generates $10 in capital income. Compare that taxpayer with one who earns the $10 in capital income and gives away $110 a year later. A deduction is neutral between the two as long as tax rates stay constant. A credit at a rate lower than the tax bracket rate of the taxpayer favors the early giver. Thus, a new world of itemized credits would create a number of new incentives and distortions with respect to the timing of giving.

[12] Individuals who donate their time to charity also effectively get an exclusion from taxation. If one person contributes $1,000 of labor to a charity, current law treats her equal to the person who earns $1,000 and then donates it to the charity to buy the same labor. A 15 percent credit mechanism would create a preference for the donation of labor over money that can be used to purchase labor.

[13] With interest deductions, there is no theoretical basis at all for a credit. The tax code favors ownership of housing mainly because such housing produces a return that is not recognized and easily measurable. When a taxpayer pays interest, and a deduction is taken, the tax code merely balances the negative interest payment of the borrower with the interest income of the lender. Elimination of the itemized deduction for home mortgage interest still leaves nontaxable the return generated by equity owners; it merely penalizes the homeowner who is required to borrow -- and in proportion to the amount of the borrowing, not the amount of the income that avoids taxation.

[14] To complicate matters more, interest receipts are not subject to a credit rate, nor are business interest expenses going to be granted only a credit. Putting interest receipts and deductions into the right pile would be more important than ever with a credit that applied only to some interest expenses and would complicate tax planning significantly.

[15] Casualty and theft losses are subject to a fairly severe floor already. Moreover, they have been cut back significantly in recent reforms. What remains are mainly extraordinary losses that many tax theorists would recognize as legitimate corrections necessary to measure net well-being or income properly. Some proposals to convert itemized deductions to credits would transfer these losses to another part of the tax return so that the deduction would remain.

[16] The current schedule for itemized deductions allows miscellaneous itemized deductions to be taken in two different places. Most of these expenses already are not deductible unless they exceed a floor of 2 percent of income. Unreimbursed employee expenses, tax preparation fees, investment expenses, and similar miscellaneous expenses legitimately represent costs of generating income. As such, they are appropriate to take as deductions, whether on the itemized deduction schedule, or, for some taxpayers, on forms for reporting income from self-employment or partnerships. The goal of the miscellaneous itemized deduction is to measure net income more correctly; a credit could not serve that goal. If there are compliance or other problems here, they should be addressed more directly, but not simply by converting the deduction to a credit.

[17] In sum, the right way to conduct tax reform is the hard way: each item of the code needs to be examined one by one to determine if the allowed adjustment is appropriate to measure income or the ability to pay tax of each taxpayer. Sometimes the beneficiary of a transfer should pay tax in theory, but a deduction may still be appropriate for the transferor of state and local taxes or charitable gifts. Finally, deductions often are simpler and more neutral among similar types of income or expenditure. These comments do not imply that it is impossible to simplify and pare itemized deductions. Indeed, paring has already been done over the years through a variety of mechanisms such as the standard deduction and various floors and ceilings. A flat rate credit simply is too crude a mechanism to apply to most or all itemized expenses and usually lacks any strong theoretical basis.

Tax Analysts Information

Code Section: Tax Policy
Jurisdiction: United States
Subject Area: Legislative and Policy Issues
Index Terms: deductions
credits
Author: Steuerle, Gene
Institutional Author: Tax Analysts
Tax Analysts Document Number: Doc 97-11703 (2 pages)
Tax Analysts Electronic Citation: 97 TNT 81-63
Cross Reference: