Deductions, Credits and Tax Reform

November 19, 2010

Two recent proposals to reduce the federal deficit call for substantial tax 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 base 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 deduction and a tax credit? 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 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 tax 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 bracket. 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 surtax. 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 withholding, 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.

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