Restrictions on Itemized Tax Deductions: Policy Options and Analysis
Released: 2014-03-10T00:00:00

Introduction

The President and some leading Members of Congress have indicated that income tax reform is a major policy objective. The House Budget Resolution ( H.Con.Res. 25 ) supports a revenue-neutral reform that would broaden the individual income tax base and lower statutory income tax rates, while the Senate Budget Resolution ( S.Con.Res. 8 ) proposes revenue raising through base-broadening. The President has proposed substantive tax policy changes in his budget outlines. Further, both tax-writing committees have held hearings and have working groups on tax reform.

Most tax provisions that might be considered for base-broadening are contained in a list of tax expenditures. Itemized deductions are a group of tax expenditures likely to be considered as important candidates for reform. The major itemized deductions are for mortgage interest, state and local taxes, charitable contributions, and medical costs. The Ways and Means Committee has recently held hearings on provisions affecting state and local governments, charitable contributions, and housing tax provisions (including the home mortgage interest deduction).

Itemized deductions account for about one-fifth of all tax expenditures, and may be easy targets of reform, based on their visibility and some policy grounds. In particular, itemized deductions are already listed on the 1040 income tax form and are easily measured. Eliminating some of them might contribute to tax simplification (unlike revisions such as including employee fringe benefits in income). At the same time, itemized deductions have broad support, and are claimed by roughly one-third of tax filers. Arguments can be made to justify some of these deductions and some of them are among the longest-standing provisions of the federal income tax code (see Appendix A for a brief history of itemized deductions).

Reducing incentives and subsidies that alter taxpayers' choices is one potential objective of tax reform. In addition, as suggested by the differing budget resolutions, some proponents of reform see broadening the tax base as a means of raising revenue without raising tax rates, while others see it as a way to pay for reduced tax rates. For a given revenue target, tax reform can involve a trade-off between a broader base and lower rates. In addition, as outlined in this report, base-broadening could have unintended side effects, such as effects on savings incentives or the labor supply.

A variety of proposals for limiting itemized deductions, either as an overall proposition or through specific revisions to certain deductions, have been advanced by policy makers, economists, and tax experts. This report discusses the proposals that have been advanced, their potential revenue gain, their consequences for taxpayer behavior and economic efficiency, their distributional implications, and administrative and transition issues that may arise.

Although this report provides some background material, it assumes some familiarity with itemized tax deductions, and the debate surrounding their reform. For an introduction to tax deductions, see CRS Report R42872, Tax Deductions for Individuals: A Summary , by [author name scrubbed]. For general tax data analysis on itemized tax deductions, see CRS Report R43012, Itemized Tax Deductions for Individuals: Data Analysis , by [author name scrubbed].

An Overview of Itemized Deductions

Individual income tax filers have the option to claim either a standard deduction or the sum of their itemized deductions on the federal income tax Form 1040. The standard deduction is a fixed amount, based on filing status, available to all taxpayers. Alternatively, tax filers may claim itemized deductions . Taxpayers that itemize must list each item separately on their tax return. Whichever deduction a tax filer claims—standard or itemized—the deduction amount is subtracted from adjusted gross income (AGI) in the process of determining taxable income. AGI is the basic measure of income under the federal income tax and is the income measurement before itemized or standard deductions and personal exemptions are taken into account.

Generally, only individuals with aggregate itemized deductions greater than the standard deduction find it worthwhile to itemize. The tax benefit of choosing to itemize is the amount that their itemized deductions exceed the standard deduction, multiplied by their top marginal income tax rate.

About one-third of taxpayers, largely in the middle and upper income parts of the income distribution, itemize deductions. At incomes of more than $200,000, 95% or more of taxpayers itemized, although two-thirds of itemizers had incomes below $100,000. Therefore while the benefits of itemizing are more concentrated in higher incomes, many middle-class taxpayers itemize deductions.

Types of Itemized Deductions

Itemized deductions are often grouped together in broader discussions of tax policy, in part because they are grouped together on the tax Form 1040. But, itemized deductions exist for a variety of reasons, can affect different types of economic behavior, and are designed in ways such that they target (or exclude) different types of tax filers.

One way to distinguish between different types of itemized deductions is whether they are classified as tax expenditures. Tax expenditures are defined under the Congressional Budget and Impoundment Control Act of 1974 ( P.L. 93-344 ) as "revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability." The Joint Committee on Taxation (JCT) also provides annual revenue loss estimates for tax expenditures.

In contrast, some itemized deductions are not classified as tax expenditures because they generally are appropriate to use to measure income (such as employee job expenses). These provisions might be contained in the form of an itemized deduction for reasons of simplifying tax compliance and administration, so that taxpayers do not keep track of and deduct small amounts, or so most taxpayers will not have to encounter provisions that apply to limited numbers of taxpayers on other, simpler, tax forms.

Detailed tables showing the number of claimants and the size of deductions for each type of itemized deduction are shown in Appendix A . Four basic itemized deductions, summing to $1.1 trillion of deductions in 2010, constitute those classified as tax expenditures:

State and local deductions for income, sales, and property taxes totaled $442 billion in 2010. Tax deductions for state income taxes were the largest at $246 billion, followed by real estate property taxes at $172 billion. Optional sales tax deductions (which are part of the temporary provisions termed "extenders" and, absent legislation, will expire after 2013) were $16 billion. Tax deductions for state and local personal property taxes (on motor vehicles) were $7 billion. Mortgage interest deductions totaled $401 billion in 2010. Less than $2 billion of that amount was for home equity loan points, and less than $7 billion for qualified mortgage insurance premiums. The latter is also an "extender." Charitable contribution deductions totaled $172 billion in 2010. Of these deductible contributions, $135 billion was in cash, $44 billion in property, and $31 billion carried over from prior years (due to limits on deductions as a percentage of income). Medical and dental expense deductions above the 7.5% floor totaled $85 billion in 2010.

These deductions have diverse purposes. Notably, for example, the deduction of extraordinary medical expenses is not an incentive to encourage spending but a provision to reflect ability to pay taxes. State and local income taxes are not under the control of the taxpayer in the short run (and cannot be avoided other than relocating), but the deduction may encourage state and local governments to enact these taxes. Benefits for homeownership and charitable contributions, however, arise from explicit choices of the taxpayer and are incentives to make the choice to own a home or donate to charity.

Itemized deductions not classified as tax expenditures were $264 billion, although only $117 billion were allowed because many of these deductions are subject, as a group, to a floor and only amounts in excess of 2% of income are deducted. Examples of these itemized deductions (some limited and some not) are investment interest expenses, unreimbursed employee expenses, tax preparation expenses, other costs of earning income, such as investment expenses, and gambling losses. These deductions would likely need to be deducted elsewhere on the tax Form 1040 if itemized deductions were repealed.

Limits on Itemized Deductions and "Pease"

Numerous restrictions are on itemized deductions in the form of floors or ceilings, which may be in dollar amounts or percentage-of-income amounts. A floor means that only deductions in excess of a certain amount are allowed. A ceiling means that only deductions up to a certain amount are allowed. There is also a so called "limitation" on the amount of itemized deductions that certain higher-income tax filers are subject to. Pease applies to tax filers with an AGI over $250,000 ($275,000 for head of household filers and $300,000 for married joint filers). Pease is, however, not a true limit on deductions, but rather an increased tax rate.

Floors and Ceilings

Two itemized deductions are subject to caps or ceilings. Mortgage interest deductions are allowed for interest on the first $1 million of a mortgage. In addition, while interest on home equity loans can be deducted, only interest associated with up to $100,000 of loans is deductible.

Whereas the mortgage interest deduction is subject to a dollar ceiling, charitable contributions are subject to percentage-of-income ceilings, although those ceilings are so high that few taxpayers encounter them. Cash contributions are limited to 50% of income and to 30% of income for contributions to certain types of nonprofits, mainly foundations. These limits are lower for charitable contributions of appreciated property: 30% and 20%. In effect, the limits prevent individuals from wiping out too much of their tax liability via charitable deductions. Any unused deductions can also be carried over and deducted in future years.

There is a special provision related to charitable contributions, although not explicitly an itemized deduction, which allows individuals aged 70½ or older to contribute IRA withdrawals directly to charity without including them in income and then deducting them (if the individual itemizes); this amount is capped at $100,000.

Two itemized deductions considered tax expenditures are subject to a floor: extraordinary medical and dental expenses and casualty and theft losses. Currently, only medical deductions in excess of 10% of AGI are allowable (7.5% until 2016 for returns where at least one taxpayer is aged 65 or older). Casualty and theft losses are limited to the excess over $100 and that excess can only be deducted if over 10% of income. Of the itemized deductions not classified as tax expenditures, employee expenses, tax preparation expenses, and certain other miscellaneous deductions are limited, as a group, to amounts in excess of 2% of income.

The Pease "Limitation"

Some might ask why policy makers would consider new policies to limit itemized deductions when one "already exists" in the form of Pease. Pease, however, is designed in such a way that it is unlikely to have an effect on the value of itemized deductions.

Pease is not a true limit on itemized deductions because it is triggered by an AGI threshold— not the amount of deductions claimed. For affected tax filers, the total of certain itemized deductions is reduced by 3% of the amount of AGI exceeding the threshold. The total reduction, however, cannot be greater than 80% of the value of the deductions (and the tax filer always has the option of taking the standard deduction).

Pease's limitations are triggered by an AGI threshold and are implemented like an additional tax rate rather than a true limit on deductions. For a tax filer affected by Pease, a $1.00 increase in AGI will increase taxable income by $1.03 because itemized deductions have been decreased by $0.03 (an increase of itemized deductions of $1 will decrease taxable income by $1). Consequently, the effective marginal tax rate will be 3% higher than the statutory marginal tax rate. For example, a tax filer in the 33% tax bracket faces an effective marginal tax rate of 33.99%—an increase of about 1 percentage point. These effects are not directly linked to deduction claims.

Pease's total reduction (or increase in taxable income) cannot be greater than 80% of the deductions. If this limit were reached then the value of itemized deductions would be affected. Higher-income itemizers are unlikely to hit this 80% limit because some common deductions increase at a rate greater than Pease's 3% surtax. For example, if a tax filer claimed an itemized deduction for state income taxes set at a 5% rate, then the amount claimed for the deduction would increase at a faster rate than the amount of increased taxable income under Pease.

An Overview of Issues and Options for Revision

A range of options could reform or restrict itemized deductions. The options for revisions generally fall into two basic types: overall limits on the size or value of itemized deductions in general through caps, floors, or limits on tax benefit and specific revisions to particular itemized deductions.

These restrictions could be justified in several different ways, including

to increase federal revenue; to allow a reduction in statutory tax rates, while holding revenue constant; to reduce economic distortions, where individuals pursue economic behaviors that they would not otherwise do, absent the influences of tax policy (also referred to as inefficiencies ); to increase the progressivity of the federal income tax (an issue of vertical equity ); to reduce discrepancies in the taxation of individuals with similar abilities to pay taxes (also referred to as horizontal equity ); or to simplify the tax code.

This section provides a brief overview of these issues. The subsequent analysis explains the various options and provides more detailed analysis of them considering the issues of revenue, efficiency, distribution, and simplicity.

Revenue Effects

With regard to raising revenue, some might argue that there is less potential revenue to be raised by restricting itemized deductions than from restricting larger tax expenditures. The tax exclusion of employer contributions for health care, exclusion of contributions and earnings to retirement plans, and the reduced tax rates on dividends and long-term capital gains are larger sources of annual revenue loss than the largest itemized deduction (the deduction for home mortgage interest). These options may be limited for a variety of reasons, including difficulties in imputing income (as in the case of the present value of defined-benefit pension plans), difficulties in limiting the effects on middle-class taxpayers (as in the case of employer-provided health benefits), desires to protect savings incentives, or aversions to potential behavioral effects that reduce revenue (as in the case of capital gains).

The maximum revenue gain from an elimination of itemized deductions is projected at $190 billion in 2015, which is 12% of individual income taxes and 44% of the projected deficit under the Congressional Budget Office's (CBO's) standard baseline. Proposals to limit itemized deductions would raise less revenue, in some cases only a small share of the revenue from full elimination.

Effects of Base-Broadening on Marginal Tax Rates, Labor Supply, and Saving

The increasing attention to across-the-board proposals for itemized deductions and, in some cases, other tax expenditures, suggests that the primary focus of base-broadening for some could be the goal of lowering tax rates (or preventing them from rising due to revenue needs) rather than reducing subsidies for undesirable or inefficient activities. Some are interested in keeping statutory tax rates low because they presume that lower rates limit the distorting effects of taxes on wage and capital income, thereby also limiting the effect of taxes on labor supply and savings rates (which are components of long-term growth).

This objective may not be obtainable, as there are many circumstances where restrictions on itemized deductions have similar effects to increases in tax rates; thus base broadening to permit lower rates should not be expected have a supply-side effect. As explained below, it is not the effect of pushing taxpayers into a higher rate bracket, but affecting the tax collected from a marginal dollar of income, which affects taxpayers in the top bracket as well as those in other brackets. This effect is often on the periphery of tax reform discussions, but it is an important issue because designing an efficient proposal to reform itemized deductions that does not lead to significant increases in effective marginal rates may conflict with distributional objectives.

A recent article by Martin Sullivan, Chief Economist at Tax Analysts, argued the narrower point that base-broadening can increase marginal tax rates because, in some cases, because base-broadening expands taxable income enough for some itemizers to push them into higher tax brackets. Of course, this effect would not apply to the highest tax bracket because these tax filers are already being taxed at the top marginal tax rate.

While this effect could certainly be a concern for some, there is a much more important and direct relationship between base-broadening, through restricting itemized deductions, and effective marginal tax rates. Whereas the statutory income tax rates are set in law, the effective tax rates at the margin are the share of an additional dollar of income that is paid in taxes. If part of an additional dollar of earnings is spent in a way that generates a tax deduction, it reduces the effective marginal tax rate (EMTR) for that tax filer. If that deduction is eliminated, then the EMTR rises. It is the EMTR—not the statutory tax rate—that could discourage the supply of labor or savings. Despite this potential concern, from a theoretical perspective, prior studies indicate that there is not a consensus among economists whether these marginal effects are statistically or economically significant.

The most straightforward example of this effect is the itemized deduction for state and local income taxes. According to IRS statistics in 2010, the average deduction on itemized returns for state and local income taxes was 5.5% of income for those with an AGI of $200,000 or greater. Because most state income tax rates are progressive, income taxes paid as a share of income would be even higher at the margin. Using an example of 6%, if the federal statutory income tax rate is 35%, and the state income tax is deductible, the total EMTR is 35% plus 6% minus the value of the tax deduction (0.35 times 6%), or 38.9%. If the state and local income tax deduction is eliminated or capped, the EMTR rises to 41% (35% plus 6%). On average then, disallowing the state income tax deduction is the equivalent of raising the EMTR by 2.1 percentage points for those tax filers that would otherwise claim the deduction. Put another way, retaining the state and local deduction and simply raising the federal statutory rate to 37.2% for this bracket would achieve the same effect.

As will be discussed in more detail when specific options are considered, how much of an increase in EMTR occurs depends on the nature of the proposed change, as some approaches are more likely to affect these marginal rates than others, across the various income groups. Similarly some itemized deductions are more likely to have a larger effect on marginal tax rates relative to revenue gain than others.

Behavioral Effects and Allocative Efficiency

Itemized deductions were enacted into the federal tax code to serve a particular purpose. Whether they were enacted to reflect the costs of generating income (such as the deduction for unreimbursed employee expenses) or promote certain goals of social policy (such as the deduction for charitable contributions), the net effects of these provisions were deemed desirable enough by a past Congress to be enacted and by many past Congresses to retain.

Yet traditional tax reform presumes that provisions that are to be eliminated or constrained are undesirable in some fashion and one of the arguments is that they distort the allocation of resources. This concern suggests specific attention to the itemized deductions one by one. In many cases, while there may be arguments that itemized deductions distort spending in favor of housing, charity, or state and local services financed by deductible taxes, there may also be some justifications for favoring this type of spending.

Distributional Issues

Some might see raising revenue through restrictions on itemized deductions as one approach to further concentrate the share of income tax paid by those with higher incomes because itemizing is concentrated in the higher incomes. Others might oppose restrictions on itemized deductions based on distributional or equity reasons. Higher-income tax filers already provide most of the revenue collected through the individual federal income tax, and thus some might oppose further efforts to increase the progressivity of the federal income tax code.

Itemized deduction provisions might also be restricted based on the grounds of horizontal equity. Currently, there are tax provisions that favor individuals who have a preference for home ownership, or for charity, or for living in areas that provide a high level of state and local service. On the other hand, itemized deductions may increase horizontal equity in some instances, for example, between homeowners who can finance more of their home out of assets and those who need larger mortgages. Allowing a deduction for extraordinary medical expenses may also treat those with the same ability to pay more equitably, because a family with these expenses has a lower ability to pay than a family without them.

Simplification and Administration

One objective of tax reform may be to simplify the tax code. Eliminating itemized deductions, for example, would simplify tax filings and compliance because taxpayers would take a standard deduction. In some instances, retaining the deductions and placing restrictions on them could further complicate tax planning and tax filing.

Options for Across-the-Board Limits

Many of the proposals recently advanced would address itemized deductions (or other tax expenditures) in the aggregate. Some of these options include dollar or percentage of income limits on deductions, limits on the value of tax deductions, or elimination of a percentage of, or all of, deductions.

Flat Dollar Value Caps

Caps generally are meant to reduce the extent that tax provisions can distort economic behavior, limit revenue losses, or reduce the availability of the deduction to higher-income tax filers. Dollar caps currently apply to itemized deductions for home mortgage interest.

Some have proposed using caps in the form of an across-the-board limit on itemized deductions based on a flat, dollar-value (hereinafter referred to as the "flat-cap" option). Proposals on the exact value of a flat-cap have varied from $17,000 to $50,000 per joint tax filing unit. An additional flat-cap on itemized deductions would add complexity to the process of filing taxes. Compared with some other reform options, though, the flat-cap is simpler because it is not dependent on calculations of income or other tax benefits (e.g., exemptions). Tax filers who anticipate itemizing their deductions can tally their deduction-eligible activities (e.g., charitable contributions or home mortgage interest) as they go. A flat-cap proposal could also be structured in a way to exclude deductions for unusual expenses that reduce a tax filer's ability to pay taxes, such as extraordinary medical expenses and casualty and theft losses.

If a tax filer potentially has deductions that exceed a flat-dollar value cap, then they could have to choose which deductions they will actually claim. Table 1 shows the average deductions in each income class to provide a general idea of what types of taxpayers might be affected. For example, a $17,000 cap would affect most itemizers (approximately 71%), while a $50,000 cap would largely affect itemizers with incomes above $250,000 (totaling approximately 6% of all itemizers).

Taxpayers with deductions above the cap would lose the marginal incentives associated with these deductions and their behavior might be affected. After enactment of a flat-cap, deductible activities that are more easily adjustable in the short run (e.g., charitable contributions) could be reduced, which could push other deductions under the limit. Prospective homebuyers might reduce the size of their home purchase or opt for rental housing. Taxpayers with sufficient assets might pay down some or all of their mortgages. Other adjustments, such as mortgages for middle income homeowners or state and local income taxes, may be more difficult to make or make quickly.

Percentage of AGI Caps

Another option to cap itemized deduction amounts would be to restrict total claim amounts to a certain percentage of the tax filer's AGI (hereinafter referred to as an "AGI cap"). This option would add complexity to the tax-filing process by requiring an itemizer to additionally calculate their total itemized deduction claims as a share of their AGI.

Compared with the flat dollar-value cap, an AGI cap would be less likely to cause the relative tradeoff effects between claiming certain deductions. Some itemized deductions tend to grow proportionately with income under an AGI cap (such as state and local income taxes) or at slower rate than income.

Table 2 shows the amounts claimed for certain itemized deductions as a share of the total income of itemizers. The total itemized deductions claimed as a share of the total income claimed were less for the higher-income tax filers than those tax filers in the lower or middle sections of the income distribution. Thus, a broad cap on itemized deductions based on AGI cannot be targeted in a way that primarily affects higher-income earners without affecting lower- or middle-income earners.

The data in Table 2 show that some itemized deductions comprise a larger share of income of higher-income earners. If a policy goal is to minimize the negative effects of a cap on middle-income tax filers, an AGI cap could be applied only to certain deductions, such as the deduction for state and local taxes or charitable gifts in order to reduce the effect of the cap on itemizers in the middle of the income distribution.

Tax Benefit Value Caps

Another way to restrict itemized deductions is by limiting the value of certain provisions rather than the claims. In contrast to limits on deduction claims (which would be calculated before applying the progressive statutory income tax rates), a limit on the value (tax benefit to the tax filer) of certain tax provisions would be calculated after applying their tax rates. That is, one approach limits the deductions taken, while the other limits the effect of those deductions on tax liability. Two types of restrictions have been suggested: limiting the marginal tax rate at which deductions are valued or limiting the total value of itemized deductions to a percentage of income.

Restrictions on the tax value of deductions tend to affect tax filers facing higher marginal income tax rates (than those facing lower marginal tax rates) because the tax value of itemized deductions increases as marginal rates increase.

Limiting the Tax Rate at Which Deductions are Valued

In his FY2015 budget recommendation, President Obama proposed limiting the tax rate that applies to itemized deductions, certain above-the-line deductions, and certain income exclusions to 28% for tax filers in the top three brackets (33%, 35%, and 39.6%). Taxpayers affected would generally be those with incomes of $250,000 or more. Earlier budget outlines had proposed these restrictions for itemized deductions only.

Limiting the Total Value of Deductions as a Share of Income

Researchers Martin Feldstein, Dan Feenberg, and Maya Maguineas (2011) proposed another option (hereinafter referred to as "FFM") to limit the total value that certain tax expenditures, including itemized deductions, can reduce one's tax burden as a share of AGI. The initial FFM proposal called for limiting the value of certain tax expenditures to 2% of a tax filer's AGI. Specifically, FFM would apply only to the sum of (1) total itemized deductions, (2) the exclusion for health insurance costs, and (3) a number of tax credits (e.g., the child tax credit). The researchers chose these tax provisions because they are among some of the largest tax expenditures in the federal income tax code. According to Martin Feldstein, the goal of this proposal is to both enhance progressivity in the tax system and reduce tax expenditures (i.e., the loss of revenue), among other things, without changes to the statutory tax rates.

If applied to the itemized deductions alone, this provision would limit deductions more for higher-income taxpayers than the limit on deductions as a percentage of income. Limiting the value of itemized deductions to 2% of income would be the equivalent of limiting deductions for taxpayers in the 15% bracket to 13.3% (because 0.15 times 13.3% equals 2%), whereas for taxpayers in the top bracket, it would be equivalent to a 5% limit (2% dividend by 0.396).

The original FFM proposal has since been amended by the Committee for a Responsible Federal Budget (CRFB) to include additional policy options to focus on higher-income tax filers. The rationale for this targeted approach is that more than 40% of tax expenditures accrue to those with annual incomes above $200,000. These options include a $10,000 flat-cap; phasing in FFM for tax filers earning between $250,000 and $500,000; or including additional tax expenditures under the original FFM proposal.

Floors

As noted earlier some itemized deductions can only be claimed if they meet or exceed minimum threshold amounts (usually a certain percentage of AGI) in order to simplify tax administration and compliance or confine deductions to extraordinary expenditures. An option that could raise revenue while preserving the marginal incentives in many cases is an overall floor, with deductions allowed only in excess of that amount. The floor could be a dollar floor or a percentage of income floors. As implied by data in Table 1 and Table 2 dollar floors are more restrictive for lower-income itemizers, whereas percentage of income floors would proportionally reduce deductions more at the higher-income levels. For example, a 5% floor would eliminate, for the average taxpayer in the $1 million or more income class, 37% of deductions, whereas it would eliminate 24% of deductions in the $100,000 to $200,000 class.

Although a floor is an across-the-board option, it has more frequently been proposed for specific provisions whose marginal effects are more likely to be considered desirable, such as charitable contributions.

Convert Deductions to Credits

One option for reforming itemized deductions is to convert them into credits. Proponents of converting deductions to credits argue that credits are fairer than deductions because a taxpayer that faces a lower marginal tax rate benefits less from a deduction than a taxpayer facing a higher marginal tax rate, even if they have identical expenses (e.g., the same mortgage interest expenses). On the other hand, opponents of converting deductions to credits argue that the reduced value of the tax preference (particularly for higher-income individuals) might reduce the incentives for certain individuals to engage in what some believe are desirable activities. Credits could be structured as non-refundable or refundable. In the case of a refundable credit, the dollar-for-dollar reduction in tax liability is the same regardless of a taxpayer's marginal tax rate—even if the taxpayer has no tax liability.

If credits are allowed for all taxpayers, those taking the standard deduction would also qualify and this extension of benefits would limit any revenue gains as well as complicate tax filing. Credits could be restricted to those who do not take the standard deduction, however.

Some argue that the choice between structuring tax provisions as deductions or credits should depend on the purpose of the deduction. If the purpose is to correct for ability to pay taxes, then a deduction may be appropriate. If the purpose is to encourage certain types of behavior (e.g., charitable contributions), it is less clear whether credits or deductions would be the preferred method. If tax filers have a greater response to tax subsidies at higher incomes, it could be more efficient to use deductions to present lower after-tax prices for these taxpayers.

Elimination or Proportional Cutbacks of All Itemized Deductions

Eliminating all itemized deductions could reduce tax compliance costs for tax filers, potentially reduce some economic inefficiencies, and eliminate the unequal value of itemized deductions between tax filers facing higher marginal tax rates compared with tax filers facing lower tax rates.

Although cases can be made for restricting, reforming, or even eliminating certain itemized deductions, the variety of justifications for itemized deductions makes it difficult to make a compelling argument for eliminating all itemized deductions.

The 2010 Chairmen's Mark of the President's National Commission on Fiscal Responsibility and Reform (hereinafter referred to as "Simpson-Bowles") calls for an elimination of all itemized deductions, and a conversion of selected tax expenditures to credits. Simpson-Bowles would still allow taxpayers to claim a standard deduction and any personal exemptions for dependents. Deductions for mortgage interest and charitable contributions would be replaced with 12% non-refundable tax credits available for all tax filers. Only charitable contributions in excess of 2% of income would be eligible for the credit.

The Domenici-Rivlin (D-R) Debt Reduction Task Force also calls for an elimination of itemized deductions, while converting selected tax expenditures into refundable tax credits. Specifically, the D-R proposal would allow all taxpayers to claim a 20% credit for home mortgage interest expenses on a principal residence up to $25,000. The mortgage interest credit would then be phased down from 20% to 15% over five years. The D-R proposal would also allow a 15% refundable credit for charitable contributions.

The D-R proposal also calls for changes in tax administration in areas that are currently in the form of an itemized deduction, such that mortgage brokers and charities apply to the IRS for a matching grant to supplement payments from taxpayers. For example, for every $85 a taxpayer gives, the charity would receive another $15 or mortgage lenders will apply for a tax credit, which would be passed through to homeowners as a 15% reduction in their home mortgage interest payments. The purpose of structuring the D-R tax credit in this manner, according to its authors, is to reduce the need for certain individuals to file a tax return, thereby possibly reducing tax administration costs.

Even if policy makers find the original intent of itemized deductions no longer desirable, elimination of all itemized deductions that are not considered tax expenditures would change the base of income that is subject to tax. Individuals with catastrophic medical expenses would find their taxes rising perhaps beyond their ability to pay. Provision might need to be made to deduct these items elsewhere.

Rather than eliminate itemized deductions, a percentage could be disallowed. For example, if 20% of deductions are disallowed, the value of an additional dollar of deductions would be reduced by 20%.

Options for Reforms of Specific Provisions

Rather than an across-the-board limit on itemized deductions, each individual provision could be considered. Specific tax expenditures might be eliminated, or limited. The following subsections discuss some options that have been discussed in past tax reform debates for the three major categories of itemized deductions: mortgage interest, state and local taxes (including real estate property taxes), and charitable contributions. These categories represent three of the four general categories of itemized deductions that are considered tax expenditures. The floor for the fourth category, the deduction for extraordinary medical expenses, was increased recently. Thus, this remaining provision has not generally been the target of additional, specific reforms.

Mortgage-Related Deductions

The itemized deduction for home mortgage interest expenses is currently limited to interest on the first $1 million of mortgage debt, combined on a primary and secondary residence, and first $100,000 of home equity debt.

Three types of specific limits on these components of the home mortgage interest deduction could be considered. First, the current $1 million cap on mortgages eligible for interest deductions could be reduced, with $500,000 the number most commonly cited. A declining limit might also be used to eliminate the provision over time. Secondly, the mortgage interest deduction could be limited to primary residences and not extended to second, or vacation homes, as in current law. Finally, interest on home equity loans could be disallowed; or the ceiling on those whose interest is deductible (currently $100,000) may be reduced. Growth in deductions of home equity loans has been perceived to be related to the Tax Reform Act of 1986 ( P.L. 99-514 ), which ended the deduction for consumer interest other than mortgages. In part due to this tax policy, home equity lines of credit have become a substitute, to some extent, for consumer interest.

The deduction for qualified mortgage insurance premiums, which might be considered in the nature of interest, is part of the "tax extenders," temporary provisions that tend to get extended every year or two. This provision, along with other extender provisions, could be allowed to lapse.

Credits for interest paid on home mortgages would allow all homeowners with mortgages to benefit, even those who do not itemize, but because the credit extends benefits to a wider class of (mostly lower-income) taxpayers, it would likely raise less revenue and add to complexity for those additional taxpayers. It is possible, depending on the rate chosen, that a credit could result in a net revenue loss, if the value of the tax credits from new homeowners exceeds the revenue gain from higher-income tax filers whose deductions were taken at higher rates.

As noted earlier, the D-R proposal includes a matching grant for mortgage lenders to be passed along to individuals, as a substitute for the mortgage deduction.

State and Local Tax Deductions

The federal itemized deduction for state and local taxes includes state and local income, real estate, and personal property taxes. An option to choose a deduction for state and local sales taxes in lieu of the deduction for state and local income taxes is part of the extenders, which is temporarily in effect through 2013.

Each of the state and local tax deductions might be separately considered. For example, sales taxes were eliminated as a deduction in 1986, and have been introduced as an alternative deduction option only recently and also temporarily. That option could be allowed to lapse permanently. Another deduction that might be eliminated is the deduction for personal property taxes, which are generally taxes on motor vehicles. They are not imposed in many states, such as those states where taxes might be collected on motor vehicles based on weight (and thus, not deductible). Deductions for personal property taxes are claimed by a much smaller number of tax filers than the deduction for state and local income taxes (see Table A-1 in Appendix A ).

The deductions for state and local income, sales, and property taxes cover many tax filers and might be considered for more limited reforms. A cap on deductions based on a percent of adjusted gross income ("AGI cap") has been more frequently proposed than a flat-dollar cap because income taxes tend to grow constantly with income, and a dollar cap may be considered to be too harsh (especially if the flat-cap is not indexed for inflation over time). According to Table 2 , claims for the deduction for state and local income or sales taxes can be limited by an AGI cap in such a way that it primarily targets certain tax filers. For example, a 3% cap would largely focus the restriction on those with $500,000 or more of income.

Charitable Contributions

For many proposals relating to charitable contributions, a key policy concern for some is to retain the giving incentives. Thus, revision of the deduction for charitable contributions is more likely to involve floors than ceilings. A floor would only allow deductions of contributions in excess of a dollar amount or percentage of income. This approach would raise revenue while preserving more of the marginal incentive to give. It would also eliminate deductions for small amounts and the associated record-keeping.

As with mortgage interest, proposals have been made to convert the charitable contributions deduction into a credit. If allowed for non-itemizers as well, it would increase complexity and limit the revenue-raising capacity of the change. The D-R plan proposed to provide grants to charities as a substitute for credits to simplify tax administration.

Reforms for the deduction for charitable contributions could be directed specifically at gifts of property, both property that has lost value (such as clothes, household items, and automobiles) and property that has appreciated (such as art, stocks, and real estate). Overall, according to IRS statistics, gifts of property account for 26% of contributions in 2010. Gifts of household items and clothes accounted for 7%, or about a quarter of the total gifts of property. Gifts of appreciated property tend to be more concentrated among higher-income tax payers, while gifts of household items and clothes are probably more common among middle-class taxpayers.

For property without an easily established value (such as household items, clothes, art, and perhaps to some degree real estate) there is an incentive for tax filers to overstate the value so that they can claim a larger deduction. For the gifts of clothes and household items, a separate floor, a dollar ceiling, disallowing the deduction, or allowing the deduction of only a fraction of the market value are possible options to restrict the provision. The Joint Committee on Taxation (JCT), for example, proposed a $500 limit on these deductions. Allowing deduction of a fraction of the value might be sufficient to encourage donations rather than discarding these items.

Gifts of appreciated property, which account for three-quarters of the total of gifts of property, present more complex challenges. These donations have two benefits: first, the market value is deductible, and second, the difference between initial cost (basis) and market value if the asset were sold and donated as cash is not taxed as a capital gain. For assets not regularly traded (i.e., difficult to price), there is an incentive to exaggerate the value to claim a larger deduction. About 40% of these gifts of appreciated property are in stocks, about 15% are in real estate and property easements, and 3% in arts and collectibles.

More even treatment between cash and property gifts could be obtained by imposing the capital gains tax on the appreciation of charitable gifts. A stricter treatment would disallow deduction except for the basis (generally, cost of the property). Effectively, this would disallow deductions for appreciation in the value. This change would encourage the taxpayer to sell the asset and then donate the cash proceeds, which would increase the value of the charitable deduction to the taxpayer. This treatment would also deal with the problems of over-valuation by providing incentives for the individual to find a market price for the item.

Two expired tax extender provisions are also associated with charitable contributions that might be considered for reauthorization for the 2014 tax year if the itemized deduction for charitable contributions is revised. One extender allows individuals who are 70½-years-old to donate distributions from individual retirement accounts (IRAs) directly to charity without including them in their calculations of gross income. This income exclusion treatment benefits non-itemizers, and also reduces AGI and the likelihood of being taxed on Social Security benefits. If this provision were reauthorized, it might allow some individuals to circumvent floors or ceilings. A second extender deals with treatment of conservation property.

Because charitable contributions are often viewed as desirable, there are many proposals to expand the benefit, such as extending the deduction to non-itemizers (as an above-the-line deduction), allowing deductions for a particular calendar year to be made up until taxes are due on April 15 of the following year, allowing lottery winners to contribute their winnings to charity without being taxed, and expanding the allowances for direct contributions from IRAs.

Revenue Estimates for Proposals to Restrict Itemized Deductions

This section of the report presents revenue estimates for proposals to restrict itemized deductions, where available. To provide a better idea of how these changes might contribute to any base-broadening goals for tax reform, revenue gains from each proposal are converted into equivalent across-the board rate reductions that would retain revenue neutrality, as well as the potential percentage point reduction in the highest and lowest rates.

Consider first the effects of eliminating some or all of the itemized deductions. Table 3 shows the Tax Policy Center's (TPC's) revenue estimates for eliminating itemized deductions in 2015 based on estimated benefits. For example, eliminating all itemized deductions is estimated to increase revenue by $190.1 billion in 2015. If this revenue increase were used to offset revenue losses associated with a reduction in statutory tax rates, then the elimination of all itemized deductions could lead to a 10.6% across-the-board reduction in statutory tax rates (if distributed evenly across all of the marginal tax brackets). In other words, the top, statutory marginal tax bracket could be lowered by 4.2 percentage points from 39.6% to 35.4% and the lowest, statutory marginal tax bracket could be lowered by 1.1 percentage points from 10% to 8.9%.

Table 4 shows the JCT estimates for the revenue loss in 2015 for each itemized deduction classified as a tax expenditure, including the deduction for medical expenses. JCT also separates real estate taxes from others itemized deductions, leaving a tax expenditure estimate for the remaining state taxes; as noted below, about 98% of that provision is for income taxes, and the remainder of the tax expenditure estimate is for personal property taxes (sales tax deductions would have expired at that point, under current law).

Table 5 provides revenue estimates for 2015, largely drawn from the TPC, for a variety of across-the-board limits to itemized deductions, including dollar ceilings, limiting the value to 2% of adjusted gross income (FFM), and limiting the value at which the deductions can be taken to 15% and 28% (i.e., similar to the President's budget proposal for FY2014). Because some view charitable deductions as provisions that should be protected, some options exclude restricting them.

Table 6 provides estimated revenue effects in 2015 for a number of specific options that were discussed earlier for the three major itemized deductions: mortgage interest, charitable contributions, and state and local taxes. As the estimates indicate, some minor proposals would yield modest amounts of revenue. On the other hand, some options could result in significant increases in revenue, such as ceilings on the mortgage interest deduction and the floors on the charitable deduction.

Effects of Base-Broadening on Effective Marginal Tax Rates

As noted earlier, the increasing attention towards analysis of across-the-board proposals for itemized deductions and, in some cases, other tax expenditures, suggests that the primary focus of base-broadening for some could be the goal of lowering tax rates (or preventing them from rising due to revenue needs) rather than reducing subsidies for undesirable or inefficient activities. However, restricting tax provisions causes effective marginal rates to rise and could defeat the purpose of base-broadening to lower tax rates. This section discusses this issue for several types of revisions.

The effective marginal rate is affected by tax-free uses of income, many of which are embodied in itemized deductions and affect the marginal rate on all types of income (e.g., wage, investment, self-employment). In the illustrations in this section, the calculations do not take into account the reductions in effective marginal rates for all tax expenditures that might have marginal effects or the lower tax rates on capital gains. Therefore, they should be seen as an illustration of what would occur for a taxpayer whose only tax benefits are itemized deductions.

Not all itemized deductions have a marginal effect at every point along the income distribution. Some insight can be gained by looking at the pattern of deductions across income classes. If a deduction rises as income rises, it is likely that the deduction is not only marginal (affecting the last dollar of income) across all incomes, but is also higher at the margin than on average. As shown in Table 7 and in the earlier Table 2 , of the four major itemized deductions, the share of returns and AGI for two deductions tends to rise with income at almost every class over an AGI of $200,000: state income taxes and charitable gifts. If deductions rise as a share of income, the implication is that the deduction out of each marginal dollar is growing, and thus the elimination of deductions would increase effective taxation at the margin even in a revenue neutral tradeoff for lower statutory rates. If this share is falling, the deduction at the margin is smaller than the average deduction and could be zero. The mortgage interest deduction tends to decline with income at very high income levels (e.g., $10 million), which is not surprising as higher-income tax filers generally do not need to borrow as much (as a share of their income) to purchase their homes. In addition, homes may be a smaller part of these tax filers' budgets, which is also reflected in the declining value of property tax deduction claims as a share of AGI. In general, itemized deductions are a smaller percentage of itemizers' AGI as income rises.

Outside of itemized deductions other provisions may involve tax-exempt income because of exclusions from income. For example, employer-provided benefits such as health insurance and pensions (or similar benefits for the self-employed) reduce the effective marginal tax rate on earnings from wages or self-employment. However, some of these benefits, for example, tax exclusions for health insurance, are unlikely to increase with income on average, especially when income grows to very high levels. Pension benefits are more likely to be marginal because pensions are related to income. Other benefits, such as tax-exempt state and local bonds, are more likely to rise with income and be marginal in some cases because these bonds are more attractive to taxpayers with higher tax rates.

Table 7 also shows another potential issue with base-broadening through restricting itemized deductions: the "costs" of base-broadening might be concentrated among middle-income itemizers whereas the tax benefits of statutory rate reductions could spread across all tax filers. In all cases, a large share of these itemized deductions is on tax returns that have an AGI less than $200,000. Thus, if the policy goal is to protect middle-income itemizers from increased tax burdens through high ceilings, potential revenue gains are limited. For high-income taxpayers, who retain an average, but not a marginal, benefit from itemized deductions, the statutory rate reductions to keep their burden fixed would be too small to offset the rise in effective marginal tax rates from the loss of deductions at the margin. If ceilings are lowered to increase revenue and permit higher top statutory rate reductions, the burden on middle class taxpayers would increase. To avoid that effect, intermediate rates would have to be reduced, leaving less revenue for reducing the top rate (or rates).

Effects of Across-the-Board Options to Restrict Itemized Deductions on Effective Marginal Tax Rates

As is the case with restricting individual itemized deductions provisions, some of the across-the-board options for base-broadening through restrictions on itemized deductions have consequences for effective marginal tax rates (EMTRs). As previously mentioned, the EMTR is affected by tax-free uses of income, many of which are embodied in itemized deductions and which affect the marginal rate on all types of income. The calculations in the analysis and examples in the following section of this report do not take into account the reductions in EMTRs for all tax expenditures that might have marginal effects or the lower tax rates on capital gains. Nor do these calculations account for Medicare taxes, including those taxes on capital income enacted by the Patient Protection and Affordable Care Act (PPACA; P.L. 111-148 , as amended). Therefore, this analysis is only an illustration of what could occur for a taxpayer whose only benefits are itemized deductions and whose only tax is the income tax.

Table 8 provides illustrative effects of certain proposals to restrict itemized tax deductions on EMTRs for the top rate and a very high income taxpayer. These effects do not refer to any particular income level, but one high enough that the tax rate is at 39.6% (which applies to taxable income of joint returns with $450,000 or more income) and one where the assumptions regarding charitable contributions and taxes are appropriate (well in excess of $1 million).

Eliminating Some or All Itemized Deductions

Eliminating itemized deductions could raise EMTRs for tax filers across a broad range of income. As the discussion above suggests, elimination of entire categories of deductions could be problematic for some because tax filers of a wide-range of income tend to claim certain itemized deductions. Even those deductions where returns with an AGI less than $200,000 have lower claim amounts as a share of income (state and local income or sales taxes, followed by charitable contributions) have more than half of the benefit fall in lower incomes. These deductions are still likely to be marginal and increase marginal tax rates for lower-income tax filers.

For example, for a tax filer in the 25% bracket who might have marginal deductions of those in the $100,000 to $200,000 class (based on Table 2 where deductions are 20.5% of income) would have an increase in effect rate of 5.1 percentage points (0.205 times 0.25). Eliminating taxes, mortgage interest, and charity, which account for almost 15% of income, would increase rates by 3.7 percentage points with most of the increase due to provisions associated with housing (mortgage interest and real property taxes). For taxpayers in the top bracket and at very high income levels (as shown in Table 8 ), the deductions that are marginal are probably around 11%, half from taxes and half from charity, leading to a 4.4 percentage point increase.

Flat Dollar Cap on Itemized Deductions

A flat-cap approach could direct more of the revenue increase to higher-income tax filers (although heterogeneity across returns means it would not be possible to confine the effects solely to higher incomes). If the policy goal is to concentrate the effects in the highest income classes, then the dollar cap would have to be set high. According to the data in Table 1 , a flat-cap would have to be around $50,000 to largely confine the effects to taxpayers with $250,000 or more in income (most itemized returns with high incomes are joint returns). According to Table 8 , returns in the $100,000 to $200,000 income range have average deductions of 20.5% of AGI and returns in the $200,000 to $250,000 AGI range have 18.5%, so that a dollar cap equal to around 20% of the $250,000 AGI level would be needed.

Still, a flat-cap could lead to the marginal effects discussed, above. Taxpayers with incomes over $200,000 would have reduced deductions of around 8% at a minimum (based on shares for charity and state income taxes in Table 7 ). These reduced deductions would raise effective marginal tax rates on average by about 3 percentage points. For very high income tax filers, it would eliminate on average about 11% of deductions and raise rates by over 4 percentage points (0.11 times 39.6%). For the top statutory rate the effect would be to raise the effective rate of 35.2% to 39.6%.

Because of the significant trade-off between the number of tax filers subject to a flat-cap and revenue-raising potential, this option might have limited ability to broaden the base and could increase EMTRs for some tax filers. In any case where current deductions are greater than the cap, any current reduction in EMTR due to the deductions, in their current form, would be eliminated. If the flat-cap is set at relatively low levels, these increases in effective tax rates at the margin could appear across a wide range of incomes. If a flat-cap is designed to largely avoid increasing EMTRs on returns with an AGI less than $250,000, the cap would probably raise relatively little revenue (see Table 5 ) because it would retain a large non-marginal benefit for itemized deductions from a smaller pool of higher-income tax filers.

Share of AGI Cap on Itemized Deductions

A percentage of income cap on all itemized deduction claims could be used to limit the marginal tax rate effect to a smaller number of tax filers. For example, with an average deduction that is 9% of income at the margin, a percentage of income limit that is that high would, on average, not affect marginal rates for that individual.

A possible difficulty with this approach is that the constraint would be more binding on those with an AGI less than $250,000 where total itemized deduction claims are a higher share of income (see Table 2 ). It would, therefore shift a larger share of the burden of the tax increase to those below $250,000 as compared to a dollar limit. One possibility is to allow both a dollar ceiling and a percentage of income ceiling, and the tax filer can take the higher of the ceilings.

If the policy goal is to target higher-income tax filers, an alternative could involve placing percentage of income ceiling on those itemized deductions whose claims as a share of income rises at the higher-end of the income distribution. These provisions primarily include deductions for state and local income taxes and charitable gifts. For example, a 6% limit on these combined provisions would raise some revenue from tax filers with an AGI over $1 million while permitting most of the deductions to be taken by others (see Table 2 ). This proposal would still limit the increase in effective tax rates for those affected to about 1½ percentage points on average (the difference between 10% and 5% multiplied by 39.6%). For the top rate, with 11% of deductions, the rate rises by the difference between 6% and 11%, multiplied by 39.6%, for 2 percentage points.

Limiting the Value of Certain Tax Expenditures

Like other broad proposals to restrict itemized deductions, limiting the value of certain tax expenditures (including some itemized deductions) could increase EMTRs. For example, if deductions effective at the margin are 11% of income for a tax filer facing a top marginal statutory tax rate of 39.6%, then limiting the value of itemized deductions reduces the EMTR by 4 percentage points, or to 35.6%, on average. Limiting itemized deductions to 2% of income produces a rate of 37.6% because the provision reduces taxes by 2% of income at the margin. Thus the EMTR rises by 2 percentage points compared to tax policy without the limit.

Limiting the Rate at which Itemized Deductions Could be Valued

President Obama's proposal to limit the tax rate at which itemized deductions could be valued to 28% would only affect tax filers in the top two tax brackets. Based on the analysis presented here, it could increase the top EMTR by 1.3 percentage point for those tax filers facing the top income tax rate of 39.6% (deductions of 11% at the margin times the difference between 39.6% and 28%, 0.11 times 0.116). However, this approach might be limited in its ability to raise revenue, as indicated in Table 5 . This option would likely raise some revenue from itemized deductions that are not marginal.

Substituting a Credit for a Deduction

The policy option of substituting a credit for a deduction has a similar effect to the proposal to limit the rate at which deductions could be valued. In the case of a 28% credit, the effects would be the same as President Obama's proposal, although the credit would be available to non-itemizers unless it could be taken only if the standard deduction is not. For a 15% credit, more tax filers who currently itemize would encounter marginal effects. In the case of the top rate illustration, the increase in EMTR would be the difference between the rates (39.6% minus 15%) multiplied by the share of deductions (11%).

Conclusion: Issues of Effective Marginal Tax Rates

As indicated above, each of the potential approaches examined in this report could result in increases in EMTRs and some options have a limited ability to target the effects of restrictions on itemized tax deductions solely to higher-income tax filers. In these cases, policy goals aimed at raising revenue from higher-income tax filers may be harder to achieve. On the other hand, approaches that are more targeted and less likely to induce marginal tax rates have more limited potential to raise revenue.

To take one example, if all itemized deductions are eliminated, the top, statutory income tax rate would rise by around 4.4 percentage points. If an across-the-board percentage reduction in tax rates were adopted, the statutory rate could fall by 4.2 percentage points. If the across-the-board reduction in statutory tax rates is revenue neutral within income classes, the top rate reduction might be 5 percentage points at the top (as discussed in the subsequent section on distributional issues). In either case the effects are largely offsetting. For the high tax rate individuals, the tradeoff would be less favorable if dollar caps were used, because that change would raise less revenue but still have the same marginal effects.

Some of the economic analysis of the effects of restricting itemized deductions as a means to broaden the tax base to offset the revenue loss from cuts in statutory tax rates could be overlooking the effects of possible proposals on EMTRs. As discussed above, analysis of EMTRs could provide better estimates of effects on labor supply and savings, and hence economic growth, contrary to the practice of some studies. Given the recent interest in using dynamic scoring in preparing cost estimates, as expressed in the Senate budget resolution ( S.Con.Res. 8 ), the understanding of EMTRs as contrasted with statutory marginal tax rates is important if such a proposal becomes law (and if marginal tax rates affect certain types of behavior). For example, in the tradeoff between ending itemized deductions at the top for a 5 percentage point rate reduction, and a net reduction of effective marginal tax rate of 0.6 percentage points, an estimate that used the statutory rate reduction would produce behavioral effects that are more than 8 times as large as they should be (5/0.6)

Even if a proposal could lead to higher effective marginal tax rates for some tax filers, however, this issue could be of limited importance since most evidence suggests these marginal effects on labor supply and saving behavior are relatively small. Nevertheless, the analysis suggests that tax reform undertaken for the purpose of lowering statutory rates, rather than addressing the particular economic effects of the tax subsidized activities, may not accomplish its purpose.

Behavioral Effects and Allocative Efficiency

This section of the report turns to the more traditional arguments for base broadening, namely the specific merits of particular tax provisions. Presumably, a provision would be eliminated or revised for efficiency reasons if the behavior is undesirable, or if the subsidy to a desirable behavior is too large.

This discussion does not address the itemized deductions not classified as tax expenditures or the medical expense deduction, because the primary purpose of many of these provisions is to enhance vertical equity in the federal income tax code, as discussed above. In each of the other cases, both the merits of providing an incentive and the effectiveness of doing so are addressed. This section provides summaries. More detailed information and supporting references can be found in other CRS reports.

Owner-Occupied Housing: Mortgage Interest and Real Property Tax Deductions

Homeownership is sometimes presumed to be a desirable social policy goal. Economists, however, generally justify subsidies on the grounds of economic efficiency, such as the case where there is too little owner-occupied housing because individuals do not do not take into account social benefits to home ownership in making their choices. Even in the presence of a large base of literature discussing the benefits and costs of homeownership, the literature has not come to a definitive conclusion on the merits of subsidizing homeownership.

There are several positive, social benefits to homeownership, some of which result in spillover benefits (positive externalities) to other individuals in the community. Some view homeownership as benefiting communities because homeowners are thought to be more stable, maintain property better, and may be more involved citizens regarding community decisions. Homeownership can also provide a "nest egg" for retirement and is an important asset, especially of moderate income families. Economists, however, could justify subsidies on the grounds of economic efficiency if there was a market failure for homeownership. For example, there could be an undersupply of housing because private participants in the market may not be able to adequately capture the social value of the spillover benefits of homeownership.

At the same time, homeownership can also have negative effects. Homeowners may join in adopting exclusionary policies (such as large lot sizes) that restrict the supply of housing, or they may discriminate against certain groups. Homeowners could also oppose the growth of certain types of businesses in their communities, thereby limiting local sources of job creation. The concentration of assets in a home could lead to diminished diversity and increased exposure to risk in an individual's personal financial portfolio. Finally, households that cannot easily sell their home (for whatever reason) contribute to labor immobility which can cause burdens for society, such as more claims for unemployment benefits.

Overall, the magnitude of these effects has been difficult to estimate. But, they do lead to some questions about the desirability of providing such large benefits for homeownership.

With regard to the home mortgage interest and real estate property tax deductions, there are two potential effects that could be of concern to policy makers. First, they could increase the rates of homeownership and increase the average size of homes. According to empirical research on the issue, it is the tenure choice (i.e., renting versus owning), rather than the size of homes, that is more likely to lead to positive externalities in a community. Evidence, however, suggests that tenure choice is not affected very much by the tax benefits. Historically, the rate of homeownership has not changed although changes in inflation and tax rates have significantly affected the relative cost of owning versus renting. Also, homeownership rates are high in many countries without these benefits. Those on the margin between choosing to rent or own are likely to be younger or have lower incomes, and thus are less likely to itemize their deductions. Finally, the major barrier to owning a home is saving enough to provide a down payment, an issue that is not affected by the tax subsidy. The mortgage interest deduction and property tax deduction (as well as the exclusion of imputed net rent) may, instead, provide additional incentives for individuals who already intend to choose owning over renting to spend more on housing than they would absent the tax deduction.

Some proposals for restricting the deductions related to homeownership would target them more towards moderate-income individuals. These policies could include caps, limits on the value of deductions, or eliminating the benefit for secondary residences (e.g., vacation homes). Table 6 provides revenue estimates for some of these options. The current home equity loan deduction is not targeted towards a particular behavior because home equity funds can be used to finance spending unrelated to the home. Instead of these tax incentives, a more desirable alternative for some could be loan programs that make it possible for younger families to acquire homes.

The mortgage interest deduction and deduction of real property taxes are not the only provisions that reduce the cost of acquiring and maintaining a home. Economists argue that owner-occupied housing is also subsidized by the exclusion of net imputed rental income. Imagine two homeowners renting their houses to each other: they would include the rent received in income but deduct the homeownership costs, including depreciation, insurance, and maintenance as well as mortgage interest and property taxes. Thus, rather than claiming just deductions for mortgage interest and property taxes they would also increase their respective incomes by the net rental income. In other words, even if the deductions for home mortgage interest and real property taxes were eliminated, there would still be some tax benefits in place for homeowners. Moreover, eliminating deductions for home mortgage interest could put lower-income tax filers at a comparative disadvantage, as other individuals could have sufficient assets (such as higher-income tax filers) to offset the loss of tax benefits from the deduction by paying off their mortgages. Those that can pay off their mortgages effectively retain tax exemption because earnings on these assets have fallen; their net income may be no different, since they pay less interest, but also receive less capital income.

Charitable Deductions

Tax benefits for charity probably enjoy more support among economists because charitable contributions are subject to market failures due to "free-rider" problems. The free-rider issues in the charitable sector of the economy refer to the extent that contributions are often undersupplied because individual tax filers can benefit from the contributions of others (even if they do not contribute, themselves), thus giving some individuals an incentive not to contribute while still receiving the benefits of charitable activities. For example, transfers to enhance public health can provide a social benefit to donors and also to non-donors if there is a social value to non-recipients, such reduced risk of contracting illness.

Two issues, however, could make the deduction questionable. The first issue is that an individual contributor could give less to charity than the revenue loss associated with their tax deduction claim. If this were the case, then government could provide more funds for charitable purposes through grants rather than a tax deduction. This effect occurs when the elasticity of charitable contributions (percentage change in charity contributions from a 1% change in tax rates) is less than one, which most current research shows. In other words, the low elasticity found in this research indicates that changes in charitable contributions are not very responsive to changes in tax rates. The second issue is that the contributors may receive direct benefits, implicit benefits, or their contributions may go to charities that much of the population does not benefit from. For example, contributors could receive fringe benefits, such as front-row seats at the orchestra or box seats at sporting events, or may give to individual universities and art museums. In contrast, less than 8% of charitable contributions, by some estimates, goes directly to aid those in poverty.

Adding a floor to the deduction for charitable contributions is often discussed as one option for reform. A floor that permitted only large contributions relative to income, could increase the tax-induced charitable contributions per dollar of revenue loss. For example, Table 6 provides revenue estimates for three different floor options (2% of income, $500, and $1,000) for the deduction for charitable contributions. A floor could also increase tax compliance since small donations would no longer be eligible. According to the latest data available, about 14% of contributions would no longer have a marginal incentive with a 2% floor, although the revenue gain would be 37% of the total tax expenditure. The relatively larger gain in revenue compared with the reduction in incentive is because most of the value of the contributions are made by tax filers who would retain a marginal incentive to give even after disallowing contributions up to 2% of income. These individuals are more likely to be higher-income individuals.

As discussed subsequently in the section on administrative and transitional issues, some options related to the deduction for charitable contributions (including the floor and also limits on gifts of property) are also aimed at increasing tax compliance.

State and Local Income and Personal Property Tax Deductions

Deductions for state and local taxes reduce the costs to state and local governments of imposing taxes, and they could be viewed by some as a federal subsidy to the states. This implicit subsidy to the states could encourage more taxes or government services at the state and local level, or provide incentives for some states and localities to favor federally deductible taxes in their choice of revenue sources.

This assessment could lead some to question whether the federal taxpayers should subsidize activities in specific states or localities, whether via tax subsidies or via direct grants. Some government services provided by state and local governments do potentially benefit all federal taxpayers to some degree (e.g., roads) while others do not (e.g., residential waste management). Given the mobility of the population, there are some general benefits to educational services (which is also a recipient of some of the tax benefits of general obligation tax-exempt bonds). Similarly, taxpayers in one state or locality could benefit from the awareness that the poor are being cared for in another state or locality. Still, the overall spending of state and local governments tends to largely benefit their own residents. Moreover, federal tax deductions for state and local taxes are not targeted, particularly with regard to ability to pay federal income taxes. In addition, those states that have higher-income tax rates tend to also have a preference for higher levels of public goods so that taxpayers are receiving higher levels of public goods (that are exempt from income tax). Also, the fact that several states do not have income taxes creates an inequality in the benefits of federal tax deductions that vary depending on the mix of revenue sources.

Even if there is consensus among policy makers that the rationale of a federal tax subsidy for state and local governments is justified, alternatives to the current policy could still fulfill this rationale while also meeting other policy goals associated with federal tax reform. Depending on the primary policy goal, the deduction for state and local taxes could be capped at a flat-dollar or share of income, replaced with a credit, or certain types of state and local taxes could be disallowed. Table 6 provides revenue estimates for some of these options.

Distributional Effects

Economists generally approach distributional issues of tax policy through terms of vertical equity (how the tax change is distributed across income classes) and horizontal equity (the extent to which itemized deductions and changes in them might decrease or increase fairness across taxpayers similarly situated). The following section of the report analyzes various options to restrict itemized deductions from these two standards of economic equity.

Vertical Equity

Vertical equity is important to analyze because it affects how rates can be reduced if pursuing a policy that is neutral from a distributional as well as a revenue perspective. If base-broadening is primarily to raise revenue, it indicates which income groups are paying additional taxes. Some have proposed to have more revenue raised from higher income classes.

Although itemized deductions tend to benefit higher-income groups because they have more income, are more likely to itemize, and have higher tax rates, the relative concentration of tax benefits from itemized deduction differs across different provisions. According to the estimates in Table 9 , the share of tax benefits in 2012 from certain itemized deductions classified as tax expenditures for tax filers with incomes above $200,000 (the highest income range in Table 9 ) is 58% for charitable contributions and 56% for state and local taxes other than real estate. In contrast, those same tax filers receive 33% of the share of total tax benefits tax filers derived from the mortgage interest deduction and 25% share of the total tax benefits derived from the deduction for real estate taxes.

Part of the reason some of the tax benefits of certain itemized deductions are concentrated in higher-income levels is because much of the income at that level is concentrated among a smaller number of tax filers. The distribution of tax benefits relative to incomes can also be illustrated visually using concentration curves, as shown in Figure 1 . The horizontal, x-axis of the concentration curve measures the cumulative percentage of income from poorest to richest. For example, the first 15% of cumulative adjusted gross income is the income reported by the poorest 50% of taxpayers in the sample. The vertical, y-axis measures the cumulative percentage of tax benefits of a tax expenditure. If the concentration is above the 45-degree diagonal line in the figures, then the tax benefits are larger as a share of income for lower-income taxpayers. If the concentration is below the diagonal line, then the tax benefits tend to accrue to high-income taxpayers (i.e., distributed more regressively).

Note that the tax benefits for home mortgage interest, property taxes, charitable contributions and state and local sales or income taxes are each distributed regressively. The deduction for medical expenses is the only provision that exhibits some form of progressivity.

Table 10 shows estimates from the Tax Policy Center (TPC) that provide a measure of progressivity by examining the tax benefits of certain itemized deductions as a share of a tax filer's after-tax income. If tax benefits are larger as a percentage of income for higher income individuals, then the provision is making after-tax income more unequal. TPC's data do not separate out real estate taxes, so the progressivity of state and local tax deductions reflects both the less progressive real estate taxes along with the more progressive income taxes and personal property taxes.

In general, the effects of certain itemized deductions on after-tax income are relatively small for tax units with an income less than $50,000. The benefits of the mortgage interest deduction rise through the middle and upper classes, but eventually fall until they become negligible. On the other hand, the tax benefits as a share of income for the deductions for charitable gifts and state and local taxes rise with income.

The percentage increase in after-tax income as a result of certain itemized deductions can help to inform the general number of percentage points that statutory tax rates could be cut to obtain a revenue-neutral, base-broadening restriction on itemized deductions. At the $500,000 and over income level, approximately where the top, marginal statutory tax rate begins, rates could be cut: approximately 1.75 percentage points if the itemized deduction for charitable gifts were eliminated, almost 3 percentage points if the deduction for state and local tax deductions were eliminated, and about 1.2 percentage points if the deduction for mortgage interest were eliminated. Overall, the top statutory rate could be reduced by about 5 percentage points in a revenue-neutral manner if all three of these itemized deduction provisions were eliminated.

Table 11 shows the effects of various across-the-board options to restrict itemized deductions for the three highest income classes (i.e., over $200,000). For tax units in these higher-income classes, a flat-cap of $50,000 could eliminate most of the increase in after-tax income as a result of itemizing. By comparison, limiting the value to 2% of income would eliminate part of the tax benefits of itemized deductions to tax units at the highest income levels. In terms of statutory rate reductions, the $50,000 flat-cap option could permit reductions of slightly over 4 percentage points, and the limit in value to 2% of income could allow a rate reduction of 3 percentage points.

Horizontal Equity

Whereas vertical equity considers the treatment of individuals with different income and presumably tax filers with different abilities to pay, horizontal equity considers taxpayers who have similar abilities to pay but different circumstances. Many features of the tax code recognize that factors other than income (e.g., family size, health, and age) affect ability to pay income taxes.

Certain itemized deductions are viewed by some as introducing horizontal inequities. For example taxpayers who own their homes have a lower effective tax burden than renters — even if both taxpayers have the same AGI. As another example, taxpayers with a preference for charitable donations have lower tax burdens than those with other preferences.

On the other hand, some itemized deductions could increase equity across taxpayers with similar abilities to pay. For example, a family with extraordinary medical expenses has a lesser ability to pay taxes than a family without those costs. A homeowner who has financed more of their home with assets will be effectively exempt from the income those assets are earning. By this logic, allowing a mortgage interest deduction may lead to more equitable treatment between those with a larger share of their home financed by a mortgage versus those with a lower share of their home financed by a mortgage. One could argue, however, the mortgage deduction also discriminates between homeowners and renters. In the context of eliminating the deduction for state and local taxes, a taxpayer who lives in a high tax state may pay more in federal taxes if state taxes are not deductible. Whether that treatment is equitable across taxpayers depends on whether the benefits from federal spending by the state are commensurate with taxes.

Administrative and Transitional Issues

Reforms vary in the degree to which they will simplify tax administration by the government and compliance among tax filers. An outright repeal of itemized deductions, or a repeal of particular deductions, would tend to simplify both tax filing and compliance by reducing record-keeping and auditing for those deductions and reducing the general determination of whether a tax filer should choose to itemize their deductions or claim the standard deduction. Some particular reforms might also simplify tax compliance and administration. For example, applying a floor to charitable deductions could eliminate the need for record-keeping for small donations that might also be less likely to be documented. Limits on contributions of property, such as household goods and clothing, could also reduce administrative costs because these items are hard to value and monitor. Limiting the deduction for appreciated assets to basis could improve the valuation of assets by encouraging taxpayers to sell assets and donate the proceeds.

On the other hand, some approaches could add complications to tax compliance, by requiring additional computations. The proposal to limit the value of deductions, such as the President's proposal or FFM, could be particularly complicated for some tax filers as it could require computing tax liabilities under multiple additional scenarios, and perhaps re-computing the alternative minimum tax (AMT), depending on what or if modifications are made to that provision. Current rules, for example, may require three tax calculations for high-income taxpayers, the basic, an adjustment for dividends and capital gains, and for the AMT. The FFM proposal would require a separate computation to compare tax liability income, with and without deductions, to determine the limit on tax benefits, and these might also have to be coordinated with capital gains and dividends calculations, as well as the AMT. In addition, calculations compared with the standard deduction would have to be made, because it is less obvious which is better. One question that could be asked is whether producing a tax code in which tax liability may need to be calculated as many as eight different ways a desirable step in tax reform?

Although these tax computation problems could be minor with the use of tax preparation software, they still could complicate choices for individuals who prepare their own returns without software. Moreover, any type of aggregate ceiling or floor would complicate year-to-year decisions about charitable contributions, which are the most easily adjusted in the short run. Other complications may arise relating to charitable contributions. For example, in the case of revisions to the treatment of donated property, individuals wishing to donate property may now need to sell that property. These additional transactions may add complexity for them, although it may relieve the charities of that burden. Floors and ceilings could lead to shifting charitable contributions across tax years to minimize effects.

In addition to administrative issues, there are also transitional issues. These issues are probably the most serious in the case of mortgage interest deductions, in which taxpayers entered into mortgages under the assumption of tax deductibility. Especially in the case of middle-income taxpayers, the presence and size of a mortgage is quite variable and may not be offset for many taxpayers with a rate reduction if mortgages are entirely eliminated. That is, since both itemizers and non-itemizers will face the same rates, tax burdens for current itemizers will rise even if the tax reform is distributionally neutral. Two solutions to these issues are to grandfather existing mortgages and only disallow the deduction of interest on new mortgages or to slowly lower the cap on mortgages over time. A second transitional issue, relating to owner occupied housing, is the potential short-run effect on an already troubled housing market. The solution might be slowly phasing down the caps.

Brief Overview of the Ways and Means Draft Tax Reform Proposals for Itemized Deductions

On February 26, 2014, House Ways and Means Committee Chairman Camp (MI) released a discussion draft for comprehensive tax reform legislation. Relative to current law, several substantial changes to individual itemized deductions have been proposed. Some of the major changes to itemized deductions include the following:

Home mortgage interest deduction : the cap on deductions for interest on the first $1 million in home mortgage value would be reduced to $500,000 in increments over three years. Also, deductions for interest on home equity loans would be repealed. Charitable contributions deduction : would generally be subject to a 2% of AGI floor. Gifts of property would generally be valued at their cost rather than fair market value. State and local tax deductions : would be repealed (e.g., property taxes, income taxes), except for state and local taxes accrued in a trade or business. Casualty loss deduction : would be repealed for personal casualty losses (i.e., losses not connected with a trade or business or entered into profit). Medical expenses deduction : would be repealed. Miscellaneous itemized deductions : several miscellaneous itemized deductions would be repealed, including deductions for tax preparation expenses. The 2% floor for miscellaneous deductions would also be repealed. Pease : would be repealed.

The House Ways and Means proposal intends to reduce the rate of tax filers who itemize from roughly one-third now to 5%, post-reform, through a combination of (1) increasing the standard deduction (from $12,400, married filing jointly in 2014 to $22,000, post-reform), and (2) eliminating or reforming the largest itemized deductions. If successful, then reductions in the rate of itemizers would increase the effective marginal tax rates (EMTRs) of tax filers, absent other changes, for the reasons explained in the " Effects of Base-Broadening on Marginal Tax Rates, Labor Supply, and Saving " and the " Effects of Base-Broadening on Effective Marginal Tax Rates " sections of this report. If these effects were taken into account in the macroeconomic analysis of the Ways and Means draft, then it is likely that the estimated, stimulative effect of tax reform would have been less than current estimates (and possibly negative) under dynamic scoring.

As explained in the section on reforming " Charitable Deductions ," the Ways and Means draft would increase the economic efficiency of the tax code with the 2% of AGI floor. Also, as discussed in that section, valuing property gifts at basis (generally their cost of acquisition) would eliminate the ability to avoid capital gains and receive a tax deduction. The Executive Summary for the legislation claims that the entire legislation would increase charitable giving by $2.2 billion per year by improving the health of the economy. This claim is suspect, however, because (1) the draft would reduce the number of tax filers itemizing, and reduce incentives to giving for middle- and upper-middle-income tax filers (whose aggregate deduction amounts are shown in Table A-2 ); and (2) the macroeconomic effect of tax reform is uncertain due to possible effects of increasing EMTRs on growth.

The lower $500,000 cap on amount of mortgage debt available for the home mortgage interest deduction contributes to progressivity of the draft tax reform plan. Repeal of the deduction for interest paid on home equity indebtedness would increase economic efficiency by reducing the incentive for consumers to open equity lines of credit.

The repeal of the long-standing deductions for medical expenses and casualty loss would make the tax code less equitable, as these provisions are designed to better measure income and reflect a tax filer's inability to pay taxes due to catastrophic events.

Appendix A. History of and Detailed Data on Itemized Deductions

A Concise History of Itemized Deductions

Itemized deductions have existed in some form since the creation of the first, permanent, U.S. income tax code in 1913. Tax filers have been able to itemize their deductions since the Revenue Act of 1913 (P.L. 63-16), which created the first permanent federal income tax. Deductions for interest paid or unexpected casualty losses were early provisions in the federal income tax code because many businesses were sole proprietorships (i.e., pass-through entities) in which the owner was personally liable for the costs of doing business.

Tax deductions expanded during the post-World War II period between 1947 and the end of the 1970s. Itemized deductions were created for state and local taxes, certain forms of interest, charitable contributions, extraordinary health expenses, and miscellaneous expenses. As a share of personal income, these deductions grew from approximately 3.7% in 1947 to 10% in 1969, and then leveled off slightly to 9% in 1979. Some say that the growth of these itemized deductions was dampened, in part, due to increases in the standard deduction amount. The standard deduction, which was formerly based on a share of income instead of a set amount adjusted for inflation, grew from a postwar low of 2.4% of income in 1969 to 6.5% of income by 1979. This growth in the standard deduction reduced incentives for tax filers to itemize, because the value of the standard deduction exceeded the sum of their itemized deductions.

The Tax Reform Act of 1986 (TRA86) represented one of the most comprehensive tax code changes since the creation of the modern tax code in 1913. Among its main objectives, TRA86 sought to "broaden the base" of the individual income tax system, or expand the tax base without raising statutory tax rates, in a way that would provide an equitable distribution of tax reductions among individuals. With regard to the individual income tax code, TRA86 included reductions in marginal tax rates, reductions in the number of tax brackets, increase in the standard deduction, and the elimination or reformation of a variety of itemized deductions.

Within this policy framework, TRA86 eliminated some tax deductions and reformed other deductions that were left in the tax code. Deductions for state and local sales taxes were eliminated and numerous other deductions (e.g., employee business expenses, travel, and entertainment, and unreimbursed medical expenses) were limited either through higher thresholds or partial disallowance. For example, TRA86 applied restrictions on the dollar amount of the home mortgage that was eligible for interest deduction ($1 million for married filing jointly/$500,000 for married filing separately), and limited the deduction only to a primary or secondary residence.

Following TRA86, itemized deductions claims decreased in value by about one-quarter, dropping from 11.4% of personal income in 1985 to 9.2% by 1988. However, this decline in itemized deductions was partially offset in the tax base by a rise in the amount of tax filers claiming the standard deduction, whose value increased with the enactment of the TRA86.

Since TRA86, Congress has authorized new itemized deductions. These individual provisions have been regularly reauthorized as part of a package of temporary "tax extenders" and are still in-effect under current law. For example, an option to deduct state and local sales taxes in lieu of state income taxes was enacted in 2004. In addition, qualified home mortgage insurance premiums became eligible for itemized deduction in 2007.

Detailed Data on the Types of Itemized Deductions

This section of the report presents data tables of how many tax filers claimed specific itemized deductions on their tax returns, and what amount they claimed for each itemized deduction. These data come from the Internal Revenue Service's (IRS's) Statistics of Income for 2010. In the aggregate, more than 46.6 million tax filers itemized their tax deductions (rather than claim the standard deduction) for a total of more than $1.2 trillion in claim amounts.

Table A-1 and Table A-2 disaggregate the number of tax returns and the claim amounts, respectively, for itemized deductions that are classified as tax expenditures. Table A-3 and Table A-4 disaggregate the number of tax returns and the claim amounts, respectively, for itemized deductions that are not classified as tax expenditures.