It’s the time of year when taxpayers become acutely aware of what tax deductions, exemptions and credits they qualify for. After all, if a taxpayer is in the 25 percent tax bracket, a $1 tax deduction or exemption is worth 25 cents; a $1 tax credit, which is subtracted directly from one’s tax liability, is worth $1. That’s like getting a 25 percent rate of return on every $1 subtracted from one’s taxable income and a 100 percent rate of return on every $1 of tax credit.
In theory, many deductions and credits exist to encourage people to undertake certain behavior. But oftentimes they are simply rewards for what people have done anyway. This fact is shown by how often tax software or tax advisers tell taxpayers about tax incentives they qualify for that they had no idea about. Commonly overlooked tax benefits are those for higher education, which are now so numerous that a recent Congressional Research Service report required four pages of small type to list them all.
Another problem with tax incentives is that many people who qualify can’t use them because their total deductions are not large enough to go over the threshold of the standard deduction, which is $12,200 for a couple filing jointly. The standard deduction makes tax filing easier for those with a number of small deductions and no large ones. But unless the total adds up to at least $12,200, they are worthless to the taxpayer.
One area where this has significance relates to charitable contributions. Economists have long believed that this deduction has been abused by wealthy people who donate appreciated property that may have inflated values. This saves them more in taxes than it would if they sold the property and donated the proceeds because they save the capital gains tax as well as taxes on ordinary income.
The principal barrier to reforming the charitable contributions deduction is the powerful lobbying of the churches. But probably the bulk of money thrown into the collection plate each Sunday is never deducted on tax returns because most parishioners don’t keep records of cash donations or use the standard deduction.
According to the Joint Committee on Taxation, fewer than 10 percent of tax filers with incomes below $50,000 itemize, whereas 54 percent of those with incomes over $50,000 do. About 83 percent of all itemized returns are filed by those with incomes over $50,000.
Looking at the charitable contributions deduction, only 1.7 percent of the money donated to charity and deducted on tax returns was donated by those making less than $50,000. The reason is not because such people are uncharitable; it’s because they mostly use the standard deduction or have no tax liability.
For most taxpayers, the biggest deduction is for mortgage interest. It is particularly valuable because it is almost enough by itself to push taxpayers above the standard deduction. According to the Internal Revenue Service, the average mortgage interest deduction for those with incomes under $50,000 was almost $8,000 in 2010. The average property tax deduction was close to $3,000 for this group – a total almost equal to the standard deduction.
Thus homeowners with mortgages are almost always able to itemize their tax returns, thus being able to deduct charitable contributions, medical expenses, unreimbursed employee business expenses, state and local taxes other than the property tax and other deductible expenditures unavailable to those using the standard deduction.
Because tax deductions are of no value to the bulk of taxpayers and because their benefits are skewed toward the well-to-do – the higher one’s tax bracket the more taxes one saves – tax credits have become increasingly popular with both Republicans and Democrats. Especially popular is the child credit, which reduces a taxpayer’s tax liability by $1,000 for each dependent child under the age of 17.
One problem with tax credits is that they are of no value to those with no income tax liability against which to apply the credit. This has led many tax credits, such as the earned income tax credit, to be made refundable; that is, you get the credit in the form of a direct payment from the Treasury even if you have a zero income tax liability.
There are now 6 refundable credits in the tax code and a new one on the way for health insurance. The Joint Committee on Taxation expects the revenue cost of refundable credits to rise from $149 billion this year to $213 billion by 2021.
According to a recent Congressional Budget Office report, the nature of refundable credits has changed over time. Originally, they were restricted to the working poor, but are now designed more to help people purchase higher education or health insurance. Thus the IRS increasingly must not only verify taxable income, but how taxpayers spend their money as well.
The proliferation of tax deductions and credits blurs the distinction between direct government spending and tax cuts. Politically, this is important because Republicans insist that there is a fundamental difference between keeping one’s own money via a tax cut and receiving a check from the Treasury. But in the case of refundable tax credits there is literally no distinction; they are exactly the same thing.
Moreover, Republicans continue to complain about the fact that close to half of all tax filers have no tax liability – the foundation of Mitt Romney’s remark about 47 percent of Americans being dependent on government. Yet it is Republican tax policy that is primarily responsible for this phenomenon.
Some Republicans have now come to the realization that tax policies they have championed, such as the child credit, are severe barriers to tax reform. At least on the individual side it is almost impossible to expand the tax base in order to lower tax rates without imposing taxes on many of those now paying nothing or raising taxes on those now paying little.
If Republicans are unable to accomplish tax reform for this reason, it will be a case of them being hoist by their own petard.