Special Report No. 178
In discussions of raising or lowering federal income tax revenue, two common terms are PEP and Pease. These tax provisions are little known to the taxpaying public because only people with annual incomes well above average have to face the consequences of complying with them. However, these provisions are worth understanding.
Since their enactment 20 years ago, the debate over PEP and Pease has been emblematic of a larger debate in tax policy: When the government demands more revenue from taxpayers, what is the least damaging way for it to do so? Should it raise statutory tax rates or repeal targeted deductions and exemptions? And similarly, when the government decides to cut taxes, should it do so by granting more deductions and exemptions, or should it cut statutory tax rates?
This year a discussion of PEP and Pease is especially timely. For the first time in 20 years, neither law is in effect, both having been repealed for tax year 2010 and only that year. They are scheduled to be reinstated on the expiration date of the ten-year, temporary tax cuts commonly known as the Bush tax cuts. Although President Obama’s budget proposes that most of the Bush tax cuts be kept in law, he calls for PEP and Pease to be reinstated, so in all likelihood the provisions’ absence from the 1040 during 2010 will be a one-year phenomenon.
The first, PEP, refers to the personal exemption phase-out, which rescinds the benefit of the personal exemption from taxpayers who earn over a certain amount. Pease is a similar phase-out, but instead of applying to the personal exemption, it applies to most of the itemized deductions a taxpayer claims, from the well known deductions for mortgage interest, charitable gifts, and state-local taxes paid to more obscure deductions for union dues, tax preparation fees and safety deposit box expenses. Named after Representative Donald Pease (D-OH) who pushed for its enactment in 1990, this law rescinds up to 80 percent of the value of a taxpayer’s itemized deductions if the taxpayer’s income is deemed too high.
• Since its inception the federal individual income tax has used personal exemptions to mitigate the impact of taxes on low-income filers. More controversially, it has used itemized deductions to promote spending on particular products and services.
• To increase revenue over the past 20 years, the federal government has rescinded the tax benefits of personal exemptions and itemized deductions by phasing them out for high-income people. These are the so-called PEP and Pease provisions which have created significant problems, raising marginal tax rates and adding to tax complexity.
• The value of the personal exemptions and itemized deductions were gradually restored starting in 2006, and in 2010 they were completely restored by repealing the PEP and Pease provisions. However, the Obama Budget envisions restoring the PEP and Pease provisions for all single taxpayers with over $200,000 in AGI and couples with over $250,000. This will combine with statutory rate increases to significantly raise the marginal tax rates of high-wage tax filers.