Under the American Taxpayer Relief Act (ATRA), Congress restored the Pease provision of the tax code, which had been in place from 1991 to 2009 and had been briefly suspended from 2010 to 2012. Though Pease is often described as a limit on itemized deductions for high-earners, Alan Viard writes that it is better understood as a stealth tax rate increase:
Here’s how the provision — which tax geeks call the Pease provision after its author, the late Congressman Donald Pease (D-Ohio) — normally works. Taxpayers with adjusted gross incomes above a threshold are taxed on an extra amount equal to 3 percent of the excess income over the threshold. Last week’s law sets the 2013 threshold at $300,000 for married couples. So, if a couple has $800,000 of adjusted gross income, Pease adds in an extra taxable amount of $15,000 (3 percent of the $500,000 excess income), on which the couple pays $5,940 of extra tax if they’re in the 39.6 percent bracket.
What does this have to do with itemized deductions? Nothing, except for how it’s labeled. The way the $15,000 gets added to taxable income is by subtracting $15,000 from the itemized deductions that the couple would otherwise claim. If the couple has $100,000 of charitable contributions, mortgage interest, state and local taxes, and other itemized deductions, Pease reduces the allowable deduction to $85,000. Deducting $85,000 rather than $100,000 makes taxable income $15,000 higher. But, calling the $15,000 a reduction in itemized deductions, rather than some other kind of increase in taxable income, makes no economic difference. No matter how it’s labeled, the extra taxable amount doesn’t change the couple’s incentive, on the margin, to give to charity or increase other itemized deductions.
Viard concludes by observing that Pease does not reduce the incentive for charitable giving, a claim that had been made by many critics in the wake of ATRA’s passage. Indeed, the increase in the top marginal tax rate from 35 to 39.6 percent makes charitable giving more attractive to the highest earners, though it has other consequences as well.