Treasury Secretary nominee Steve Mnuchin recently promised that “there will be no absolute tax cut for the upper class” under President-elect Trump’s tax plan. While the plan would cut the top personal income tax rate from 39.6% to 33% and the capital gains and dividends tax rate from 23.8% to 20%, Mnuchin explained that these cuts would be “offset by less deductions.” Specifically, Trump has proposed to limit itemized deductions to $100,000 for singles and $200,000 for joint filers. We find that these limits will not fully offset the cost of lower tax rates for the rich. Moreover, the limits would likely have a substantial negative impact on charitable giving.
Using the American Enterprise Institute’s (AEI) Open Source Policy Center’s Tax-Calculator, a federal income tax microsimulation model, we estimate that under current law, 46 million taxpayers will claim $1.36 trillion in itemized deductions on their tax returns in 2017. Among those who itemize, the median amount of itemized deductions is $15,400 for single filers and $26,500 for married filers – well below the limits in the Trump plan.
So how many taxpayers would be affected by the proposed cap on deductions? Just 329,000, less than 1% of all itemizers. Under current law, these taxpayers will claim approximately $119 billion in itemized deductions, almost 10% of all itemized deductions. The Trump proposal will reduce allowable itemized deductions for these taxpayers by 62%, to $45 billion, while raising their average tax rate 3 percentage points. But even so, the policy raises less than half of the cost of cutting the top tax rates on personal income and capital gains and dividends.
The Trump proposal is not the first attempt to curtail itemized deductions. President Obama proposed limiting their value to a maximum of 28%, a policy that would affect itemizing taxpayers in higher tax brackets. Economist Martin Feldstein proposed to limit the amount of allowable deductions to a maximum of 2% of a taxpayer’s adjusted gross income.
Other base broadening tax reform ideas focus directly on individual itemized deductions. There have been proposals to convert the mortgage interest deduction to a 15% tax credit and to limit the deduction for charitable giving to amounts in excess of, for example, $1,000. A more straightforward approach is to simply repeal various deductions. Repealing the deduction for state and local taxes would increase tax revenues by $1.9 trillion over a decade. The recent House Republican tax reform framework proposes to eliminate all itemized deductions except for charitable giving and mortgage interest, a great simplification that preserves itemizers’ tax incentive to give to charity.
These approaches differ in their budget impact and their effect on taxpayer behavior, particularly charitable giving. Unfortunately, the Trump plan’s effects are negative and quite large, as illustrated by the following example.
Consider Mr. and Mrs. Rich, a super-high-income couple with an adjusted gross income of $5 million. Their state and local tax deduction alone exceeds Trump’s proposed $200,000 cap. Under current law, a $100,000 charitable gift would entitle the Riches to an additional tax deduction worth about $40,000, resulting in a net taxpayer cost of about $60,000. Put differently, the tax price of giving $1 is just $0.60 when the marginal tax rate is 40% – a powerful incentive for charitable giving. The Trump proposal would eliminate the Riches’ tax incentive to donate.
According to our analysis, the relatively small number of taxpayers affected by the Trump plan would otherwise claim a whopping $37 billion in charitable giving in 2017, with $27 billion above the cap. But under the Trump plan, the net cost of giving would jump from $0.60 per $1 of giving to an unsubsidized $1 per $1 of giving. The consensus from empirical evidence on the effects of the tax break on giving indicates that a 1% increase in the price yields a 1% drop in giving. In the case of the Trump proposal, $17.6 billion in annual giving could evaporate. In contrast, President Obama’s proposal, which would likely drive charitable giving down $10 billion annually, looks modest.
All in all, the Trump itemized deduction cap would raise the tax burden on high-income taxpayers relative to other features of his plan, but it is insufficient to offset the cost of the tax rate cuts for high-income earners. More significant than the distributional nuances of the plan are the economic implications. While the lower marginal rates will be good for growth, the itemized deduction cap threatens to have a very negative effect on charitable giving. As President-elect Trump works to refine his tax plan and develop his first budget, he would be wise to carefully consider both the revenue impact of his proposals and the inadvertent negative impact on giving.