The Regressivity of Deductions

June 28, 2019

The federal tax code allows individuals to reduce their tax liability through a variety of provisions, such as tax deductions, tax credits, tax exemptions, and tax exclusions. Deductions are generally available to all tax filers, but the extent to which a person benefits depends on income. The interaction of deductions with taxable income means that the payoff differs across the income spectrum.

Given our progressive income tax rate structure, deductions are more valuable to high-income individuals, meaning that tax deductions are regressive. It is important to keep the regressivity of deductions in mind when designing and analyzing policy.

Deductions are a dollar-for-dollar reduction in your taxable income. Depending on your tax bracket, this $1 deduction can mean different things for your tax bill. If you are in the lowest tax bracket (10 percent in 2019) your tax bill would be reduced by 10 percent of $1, or 10 cents. If you are in the highest tax bracket (37 percent in 2019) your tax bill would be reduced by 37 percent of $1, or 37 cents. This means that the higher your income, the greater benefit you receive from claiming a deduction.

Let’s compare what happens when three people deduct $1,000 from their income.

Table 1: The Differing Effects of a $1,000 Deduction
  Person A Person B Person C
Income $15,000 $60,000 $250,000
  Marginal Tax Rate 12% 24% 35%
Deduction $1,000 $1,000 $1,000
Reduction in Tax Bill $120 $240 $350

Table 1 shows that the dollar value of a $1,000 deduction to Person C, who earns $250,000 in income, is more than double the value of a $1,000 deduction to Person A, who earns $15,000 in income. This illustrates how the value of a deduction increases with the marginal tax rate.

Given this inherent limitation of deductions, policymakers could consider allowing a deduction based on a percentage of income, instead of a flat amount. But this structure would also be regressive.

Table 2: Deducting the Same Percent of Income
  Person A Person B Person C
Income $15,000 $60,000 $250,000
  Marginal Tax Rate 12% 24% 35%
Deduction $750 $3,000 $12,500
  As a percent of income 5% 5% 5%
Reduction in Tax Bill $90 $720 $4,375
  As a percent of income 0.60% 1.20% 1.75%

Table 2 demonstrates that deductions are regressive even when the same proportion of income is deducted across taxpayers. If each person deducts 5 percent of their pretax income, higher-income taxpayers still get to deduct a greater absolute amount. This means that Person A receives proportionately less benefit from taking a deduction than both Persons B and C because they are in a lower tax bracket.

Deductions are less valuable to low- and middle-income individuals than other provisions, such as tax credits, which are independent of a person’s income and choice to itemize. If the concern is low- and middle-income individuals, tax credits are better targeted at those populations.

Alternatively, policymakers could establish a standard marginal rate for deductions no matter the filer’s tax bracket, which would limit the inherent bias of deductions towards the wealthy.

Deductions are useful in promoting a broad and neutral tax code by allowing people and businesses to accurately classify expenses and income. Even so, lawmakers should be cognizant of their regressivity and consider whether the distribution of deductions aligns with policy goals.

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