A Breakdown of Income-Tax Deductions

by Veronique de Rugy

Federal tax code allows taxpayers to deduct certain expenses from their taxable income, hence lowering taxpayers’ overall level of tax liability. As you may know, there is a big debate right now about whether tax deductions are spending or not (the Supreme Court says it isn’t) and whether it would be a good or bad idea to do away with them in order to raise more money. So how much money are we talking about? This chart looks at income-tax deductions claimed in 2008.  

By magnitude, the top three categories of deductions claimed were on interest paid, taxes paid, and on charitable contributions. The largest category of deductions, deducted interest payments, accounted for $497.6 billion in forgone revenue in 2008. This category of deductions contains the largest single category of income-tax deduction — $470.4 billion in reduced income taxes due to reimbursed home mortgage interest payments. The remaining 5.5 percent of tax deductions in this category were from investment expenses and qualified mortgage insurance premiums.

Deductions in the second largest category, noted above as “taxes paid,” accounted for $467.2 billion in forgone income tax revenue. Sixty-two percent of these deductions were state and local income and sales taxes paid, 36 percent were due to real-estate taxes, and the remaining 2 percent were due to personal property taxes and other taxes paid. Eligible charitable contributions, medical and dental expenses, and other smaller expenses comprise the remaining deductions.

Now, setting aside the issue of whether this forgone revenue constitutes a spending issue or not, the fact remains that income tax deductions are yet another component of a riddled and biased tax system. In fact, a key aspect of fundamental tax reform would be to move us toward a broader base to which a lower tax rate would be applied.

Based on this goal, I have to disagree slightly with Ramesh’s Bloomberg article yesterday. In that piece, he calls for scaling back certain tax expenditures while also expanding refundable tax credits or taking more people off the tax roles. He’s right that we could get rid of deductions (like the state and local taxes and mortgage-interest deduction), especially if overall  marginal rates are cut. There is some evidence that these tax deductions, on average, benefit affluent households the most. However, in the context of fundamental tax reform, that seems inconsistent with the idea of expanding the per-child tax credit. Plus, why stop picking winners and losers along one dimension only to pick more winners and losers along a different one?

Finally, as I mentioned earlier, the many tax deductions endemic to our tax system have recently been identified as potential targets for deficit reduction (see Martin Feldstein here.) But would eliminating these deductions raise revenue? Logically, it should. This is why I was intrigued by this article by Gilbert Metcaf published in 2008 in the National Tax Journal, which looks specifically at the impact of eliminating the state and local income tax deduction and argues that it may not raise revenue. Metcaf finds that estimates overestimate the revenue gain from eliminating deductibility because they do not take into account a likely shift away from once-deductible taxes to non-deductible taxes and fees in the absence of deductibility. Many of these latter taxes and fees are paid by businesses. As business costs rise, federal business-tax collections would fall, offsetting some of the gains of ending deductibility. He also finds that ending deductibility would have little if any impact on state and local spending.

Here is an entire issue of National Tax Journal on the issue of tax expenditures.

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