Allow me to expand a bit on Christine's recent post on the mortgage interest deduction, which mentions in passing President Obama's proposal regarding itemized deductions.  The proposal would indeed, as the Wall Street Journal article to which Christine linked puts it, "scale back" the mortgage deduction, as well as deductions for "real-estate taxes, charitable contributions and other items." But this is not a proposal about the mortgage deduction (as real estate folks tend to claim) or about charitable contributions (as nonprofits tend to claim). Nothing is being repealed. And the proposal is not actually that shocking, for at least four reasons.

First, the proposal affects all itemized deductions, not just the mortgage deduction or the charitable deduction. Second, the proposal would limit deductions only for very high earners. Third, the proposal would only reduce, not eliminate, the benefits of itemized deductions, even for high earners. Fourth, this proposal is not anomalous, but rather would, if enacted, be only one of a number of provisions that already reduce the benefits of itemized deductions. Let's take each of these points in turn, to understand why the proposal is much less startling than it might first seem. 

First, the proposal does not target any particular deduction, but rather itemized deductions in general. What do I mean by "itemized deductions"? Some deductions, such as certain trade or business deductions, are "above-the-line" deductions. Everyone can get the benefit of these deductions. But most deductions are "below-the-line" deductions, or itemized deductions. Not everybody gets the benefit of itemized deductions, because each taxpayer has to choose between taking the standard deduction, on the one hand, and taking itemized deductions, on the other. For example, the 2009 standard deduction for a married couple was $11,400. So a married couple would itemize deductions only if their itemized deductions were more than $11,400. If their itemized deductions were less than that amount, they would not itemize, and they would get zero tax benefit from, say, making a charitable contribution of $5000. Given the size of the standard deduction, it is unsurprising that most taxpayers--about two-thirds of total tax returns--do not itemize their deductions. (In 2007, for example, only 50,544,470 out of 142,978,806 returns included itemized deductions.) Thus, about two-thirds of taxpayers already do not get the benefit of the mortgage interest deduction, the charitable deduction, real estate tax deduction, state tax deduction, and so forth. 

Second, the proposal would limit the benefits of itemized deductions only for very high-earning taxpayers. The proposal says that it would affect only married couples with an adjusted gross income (that is, total, or "gross," income minus above-the-line deductions) of more than $250,000, or individual filers with an adjusted gross income of more than $200,000. But I doubt this limit will have much effect on who the proposal would reach, because, as I explain further below, it's automatically limited only to those who pay taxes at a marginal rate of more than 28%. The 2009 tax bracket for married couples after the 28% tax bracket starts at $208,850, but that's taxable income, not adjusted gross income. That is, the $208,850 is after you reduce the adjusted gross income by personal exemptions and below-the-line deductions. In 2007, only 4,283,124 returns with itemized deductions had more than $200,000 of adjusted gross income. (And even some of those returns wouldn't get picked up by this proposal, because some of those were married couples.) So this proposal would affect approximately 2% of tax returns (based on the 2007 numbers).

Third, the proposal would not eliminate the deductions, even for those 2% of taxpayers who could be affected by it. Rather, the proposal would have an effect only to the extent that the itemized deductions reduced marginal dollars that were taxed at more than 28%. Thus, under our current tax rate structure, the proposal would at most reduce the benefit from an itemized deduction from (under current tax rates) 35 cents on the dollar to 28 cents on the dollar, a 20% reduction. For example, under current law, a $100 itemized deduction reduces taxable income by $100. If your marginal tax rate is 35%, you save $35 (35% of $100). Under the proposal, you would save $28.

Fourth, the proposal would be only one of a number of ways that, for the minority of taxpayers who do itemize, the benefit of itemized deductions is already limited. First, many itemized deductions are permitted only to the extent that such deductions exceed 2% of adjusted gross income. Second, in most years (though not 2010), most itemized deductions are partially phased out if the taxpayer earns above a certain amount. And third, the alternative minimum tax recaptures the tax benefits of itemized deductions. So even if you are a taxpayer who itemizes deductions instead of taking the standard deduction, the tax benefit you get from the deduction is less than it might initially seem.

Let's do an example, just to see what we're talking about here. The proposal wouldn't kick in until 2011, and we don't know what the tax code will look like then, or what the relevant inflation-adjusted amounts will be, so I'll use the 2009 tax brackets; estimate other inflation-adjusted amounts, such as the amount of the personal exemption and various thresholds; and allow the taxpayers to take the full amount of the personal exemption.  Also, I am making some educated guesses about how this would all work out; obviously, once we have statutory language, things could look a little different. But the below example captures, I think, the general idea.

Say you have a married couple with $250,000 adjusted gross income. To get from adjusted gross income to taxable income, they first subtract personal exemptions of $7500. They also have itemized deductions of $50,000, including some charitable deductions, some state and local taxes, a deduction for health savings account, [see Joe, in comments below] and a bad debt deduction.  Because some of these itemized deductions are permitted only to the extent they exceed 2% of the taxpayers' AGI, or $5000, the amount of itemized deductions is reduced to $45,000. They will also have to reduce their itemized deductions further, probably by 3% of the amount by which their AGI exceeds around $170,000. So they are allowed in total about $42,600 of itemized deductions. This reduces their taxable income to $199,900.

The itemized deductions that reduced their taxable income from $208,850 to $199,900 saved them tax at a rate of 28%, so those $8950 of deductions are not affected by the proposal. The remaining $33,650, however, reduced taxable income that was taxed at a marginal rate of 33%. So it saved them $11,045 (33% of $33,650). Under the proposal, they would be allowed to save only $9422 (28% of 33,650). So this proposal would increase their taxes by $1623.

Is this a good proposal? That's beyond the scope of this post (though I'd love to hear folks' thoughts about it in the comments). But if we're going to debate it, we should understand what we are really talking about.

More information:
The Joint Committee on Taxation explains the proposal.
Neil Buchanan has an excellent analysis of the proposal.
Examine data about 2007 tax returns to your heart's content.

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