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Deductions, Credits and Tax Reform

5 min readBy: Nick Kasprak

Two recent proposals to reduce the federal deficit call for substantial taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. reform. The Bowles-Simpson “Zero” Plan is so named because, among other things, it eliminates all itemized deductions in an effort to broaden the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. and lower rates. The Domenici-Rivlin proposal eliminates most itemized deductions as well, and transforms some deductions into tax credits.

So what do all these terms mean? What, exactly, is the difference between a tax deductionA tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state and local taxes paid, mortgage interest, and charitable contributions. and a tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. ? And what is the effect of switching from one to the other?

In most cases, a deduction exists because the government has decided to subsidize a particular industry. So if a taxpayer spends money on mortgage interest or gives money to a registered charity, he can subtract that amount from his taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. and owe less tax.

A credit, alternatively, is an amount that is subtracted from the amount of tax due. Therefore, a credit is worth much more than a deduction — a taxpayer in the 28% bracket pays $28 less in taxes for a $100 deduction, but pays a full $100 less for a $100 credit.

A feature of most tax deductions is regressivity; that is, deductions disproportionately benefit higher-income taxpayers. If we had only one flat taxAn income tax is referred to as a “flat tax” when all taxable income is subject to the same tax rate, regardless of income level or assets. rate, a $100 deduction would be worth the same to everyone, but because we have a stair-step structure of progressively higher tax rates, deductions have a mirror-image effect. The higher a person’s tax rate, the more valuable a deduction is. A $100 deduction lowers taxes by $35 for someone in the 35% bracket, but only $15 for someone in the 15% bracket.

Moreover, every taxpayer is entitled to a minimum “standard” deduction ($5,800 in 2011 for a single filer) and has no reason to itemize his or her deductions unless they exceed this amount. Therefore most itemized deductions are claimed by higher-income taxpayers.

The value of tax credits, on the other hand, is not dependent on a person’s tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. . A $100 tax credit is worth $100 to every filer. Also, Congress has often acted to rescind the benefits of credits from higher-income people. For example, the child tax credit starts to phase out once income rises above $110,000 for couples.

Some credits are also “refundable” – that is, their value can exceed even the amount of income tax owed. When that happens, the government pays the taxpayer instead of the other way round. Because of refundable tax credits, approximately one third of tax filers receive transfer payments from the federal government at tax time instead of paying taxes.

President Obama proposed last year to reduce the regressivity of tax deductions by limiting the benefit of all itemized deductions to 28% of the deduction amount, but the implementation was complex: for each dollar of deductions, a high-income taxpayer would face a surtaxA surtax is an additional tax levied on top of an already existing business or individual tax and can have a flat or progressive rate structure. Surtaxes are typically enacted to fund a specific program or initiative, whereas revenue from broader-based taxes, like the individual income tax, typically cover a multitude of programs and services. . A further complication would be the alternative minimum tax. (For more on this, see my previous post here.) The proposal went nowhere, likely at least in part because of its complexity. Tax deductions are fundamentally regressive if tax rates are graduated, and it’s difficult to make them less so without changing their basic structure.

This is why the Domenici-Rivlin proposal does away with deductions entirely and replaces the big ones (mortgage interest and charitable contributions) with 15% tax credits. For example, a taxpayer who contributes $10,000 to a charity would be entitled to a tax credit equal to 15% of $10,000, or $1,500, regardless of the taxpayer’s income or tax bracket. This style of reform — replacing deductions with credits — may provide an equal subsidy to the industry in question, and cost the government the same or even more in revenue, but high-income taxpayers would no longer be claiming the lion’s share of the tax preference. A tax filer would no longer need to itemize to receive the benefit of a tax credit. Conversely, the reform hurts higher-income earners because their tax rates are higher than 15%, so they don’t benefit from the new credit as much as they would have from the old deduction.

The administrative structure of the new credit raises some interesting legal issues. One of the goals of the Domenici-Rivlin proposal is to drastically reduce the number of people who would be required to file tax returns. The hope is that the tax code were simplified enough, most people would pay in the exactly correct amount in withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. , leaving no need for a tax return to adjust payment at the end of the tax year. This requires more than just changing deductions to credits. For example, here’s how the IRS could administer a charitable gift credit without requiring a tax return.

Let’s say I want to donate $1,000 to Washington National Opera (WNO). Using a normal tax credit, I would write a check for $1,000, report that donation on my tax return, and my income tax would be reduced accordingly. That wouldn’t work without a tax return, so instead, all eligible charities such as WNO would register with the IRS, and when I want to give WNO $1,000, I would send them only $850 — 85% of the contribution. WNO would report that $850 to the IRS, and the IRS would write them a check for the remaining 15% – $150. The dollar result is the same: I give up $850, and the government gives up $150, but this way I don’t have to file a return to make it happen.

The idea of the government writing checks directly to charities could raise some eyebrows – for example, what if I wanted to give that $1,000 to the Catholic Church? The government would be writing a $150 check to a religious institution, and it’s certainly possible that this could be seen as a violation of the establishment clause. If I instead decide to donate that money to Planned Parenthood, again, the government is writing a check directly to Planned Parenthood for a portion of that contribution. Even forgetting the legal issues, the politics of such a change would be acrimonious, to say the least, despite the fact that the only difference from the old system is the accounting.

The mortgage credit would work in a similar way: borrowers would pay less interest to lenders and the government would make up the difference. It’s interesting to see how a relatively simple accounting change alters the optics of the policy so dramatically, and hopefully this reform proposal, at the very least, gets people thinking about the proper role of targeted deductions and credits in tax policy.