The Pease Limitation on Itemized Deductions Is Really a Surtax

October 16, 2014

In addition to a series of tax rate increases, 2013 also brought back a more subtle tax increase for high income earners: the Pease limitation on itemized deductions. This provision, named after the late Congressman Donald Pease, reduces the value of itemized deductions for high income taxpayers. It works by reducing the value of taxpayer’s itemized deductions by 3 percent for every dollar of taxable income above a certain threshold ($254,200 single; $305,050 married). The phase-out of the value of itemized deductions is capped at 80 percent of the total value of itemized deductions.

Due to its structure, Pease is not really a limitation on itemized deductions, but rather a stealth surtax on high-income individuals. In tax reform, Pease should be repealed, but if some limitation on itemized deductions is politically necessary, a cap on certain itemized deductions would be better.

How Pease Works

A taxpayer earning $500,000 in taxable wage income would be hit with Pease. This taxpayer would be facing the top marginal income tax rate of 39.6 percent. Let’s also assume that the taxpayer lives in Michigan and faces a top marginal rate of 4.25 percent. This taxpayer would be able to deduct the income taxes paid to Michigan against his federal income tax, thus reducing the federal marginal rate by 1.68 percent to 37.92 percent.

Pease would undo some of the benefit from this deduction. In this case, it would reduce the value of the state and local income tax deduction by 3 percent on the next dollar of income and thus boosting his taxable income by an extra 3 cents. The effect of this is an increase in his marginal tax rate of 1.18 percent (3 percent of the 39.6 marginal rate). The taxpayer’s marginal rate increases from 42.1 percent to 43.35 percent.

Marginal Individual Income Tax Rate of Individual Earning $500,000

Top Marginal Federal Income Tax Rate

39.60%

Top Marginal State Income Tax Rate (Michigan)

4.25%

Deduction for State Income Taxes Paid

-1.68%

Pease Limitation

1.18%

Total

43.35%

 

This 1.18 percent increase in the taxpayer’s marginal rate lasts until Pease has phased-out 80 percent of the value of his itemized deductions.

Pease is Really a Hidden Surtax

However, in reality, most taxpayers will never hit the 80 percent cap. Itemized deductions usually increase as an individual’s income increases. In the example above, the taxpayer’s itemized deduction (the state and local income tax deduction) will always increase as his income increases because he will continue to pay more in state income taxes. As a result, Pease will continue to phase out 3 percent of every additional dollar of a taxpayer’s itemized deductions to infinity.

Pease Really Doesn’t Make Sense

From a tax policy perspective, Pease’s structure makes little sense for two main reasons.

First, if lawmakers wanted to increase the marginal tax rate on high income individuals, it would have made more sense to just increase marginal tax rates. That would have created the extra bit of progressivity without adding additional complexity. In addition, taxpayers would be more aware of the fact that the federal top marginal individual income tax rate is not actually 39.6 percent, but 40.8 percent.

Second, if reducing the value of certain itemized deductions was the goal, Pease is a less efficient means of doing so than other methods. Since Pease is connected to a taxpayer’s AGI and not the value of itemized deductions, it doesn’t really change the marginal benefit of deductions. If reducing the subsidy effect of a deduction were the goal, it would be better to target certain deductions that have little economic justification with a cap.

A cap would also be more economically efficient, since it would have a smaller effect on marginal rates, creating less of a work disincentive.

Replace or Repeal

While some itemized deductions could be considered real loopholes, many are reasonable. They are there to define taxable income for taxpayers and deal with any potential double-counting of economic activity that may occur when money is transferred from one person or business to another (e.g. Home mortgage interest deduction). Limiting these could create double-taxation and can have detrimental effects on the economy.

In future discussions about tax reform, limiting certain itemized deductions for high-income taxpayers will undoubtedly come up as a means of maintaining progressivity. If it does, lawmakers should seek to replace Pease with something more reasonable at the very least.

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