When preparing their returns, taxpayers may choose the standard deduction or they may itemize and deduct certain expenses (including state and local taxes, mortgage interest, charitable contributions, and some medical expenses) to determine their taxable income. Taxpayers benefit from itemizing when their itemized deductions exceed the amount of the standard deduction. For some types of expenses (such as medical expenses), only the amount that exceeds a given percentage of the taxpayer's adjusted gross income may be deducted. Beginning in 2013, with the expiration of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312), the total value of certain itemized deductions will be reduced if the taxpayer's adjusted gross income is above a specified threshold.
As with any deduction, the benefit of itemizing increases with a taxpayer's marginal tax rate (the rate that applies to the last dollar of income). For instance, $10,000 in deductions reduces tax liability by $1,500 for someone in the 15 percent tax bracket but by $2,800 for someone in the 28 percent tax bracket.
This option would limit the extent to which taxes can be reduced by itemizing to 15 percent of the deductions' value, thus increasing revenues by $460 billion from 2012 through 2016 and by $1,181 billion over 10 years. It would raise taxes for people in marginal tax brackets above 15 percent who itemize deductions. Most taxpayers, however, do not itemize deductions. Among the 36 percent who do, about 75 percent receive a tax benefit from itemizing that is worth more than 15 percent of their deductions. Thus, the option would affect about one out of four taxpayers.
An argument in favor of the option is that the current rules for itemizing deductions lead to too much spending on tax-favored activities because they effectively reduce the after-tax price of such activities. For example, the deduction for mortgage interest may cause homeowners to invest too much in their houses and too little elsewhere. From that perspective, reducing the benefit derived from itemizing deductions would lessen the incentive to spend money on deductible activities. That could improve the allocation of society's resources in cases in which the current subsidy has led to too much spending on those activities. But some deductions are intended to subsidize activities that have widespread benefits to the public, such as the work of charitable organizations; under certain circumstances, curtailing those deductions could worsen the allocation of resources.
Another argument in favor of the option concerns equity. The current system provides a greater tax reduction per dollar of deductible expense to higher-income taxpayers than to those with lower income. By weakening the link between deductible expenses and a household's marginal tax bracket, the option would subsidize those expenses more equitably among households with different incomes. Weakening that link could also reduce the extent to which resources are misallocated. For a given amount of subsidies, a system of uniform subsidies generally distorts taxpayer behavior less than does a system in which subsidies are large for some households and small for others.
However, in cases in which higher-income taxpayers are more sensitive than lower-income taxpayers to the after-tax price of a subsidized activity that has widespread benefits to society, eliminating the link between deductions and a household's marginal tax bracket could worsen economic efficiency by reducing the amount of resources those taxpayers allocate to such activities.
An argument against the option is that some deductions are intended to yield a measure of taxable income that more accurately reflects a person's ability to pay taxes. For example, taxpayers with large medical expenses or casualty and theft losses may have fewer resources than taxpayers with similar income and smaller expenses. Under this option, taxpayers subject to the limitation would not have those expenses fully subtracted from their taxable income.
Limiting the tax benefit of itemized deductions would alter relative tax burdens. Reducing the benefit from itemized deductions would raise average tax rates more for upper-income taxpayers than for those with lower incomes. It would also raise average tax rates more for people who incurred large deductible expenses than for those with smaller expenses.