The following article is a guest post by Justin Gordon. If interested in submitting a guest post, please ready my guest posting policy and then contact me.. Justin is a recent graduate of Temple University School of Law and majored in Political Science at USC.
The United States’ federal income tax policy is a beast; it’s no wonder why so many Americans, even educated ones, have no idea how the system works (“My accountant handles it”). The following is a brief description of how it works and one common sense reform that would bring billions in sorely-needed revenue to the government.
The way pundits on Fox News cry about taxes being 50-60%, you would think we were in France. We’re not. Not even close. America has a progressive income tax system, which means that an individual’s tax rate increases as his/her taxable base rises.
Currently, the highest percentage that someone will pay in taxes is 35%. However—and this is the crucial part—such a high-earning individual does not pay 35% on all of his/her earnings. Sorry Fox News, I know that’s something you often try to confuse your audience about, but it’s just not true. The highest-earning taxpayer only pays 35% on the income earned in EXCESS of $379,150. That’s a pretty high threshold. If you’re like most Americans, and earn under $83,600, you will not pay more than 25% in federal income taxes. Moreover, such an individual will pay less than 15% on his/her first $34,500. This is the progressive tax system: everyone pays the same percentage in taxes for each bracket he/she reaches ($8,500-$34,500: 15%; $34,500-$83,600: 25%; $83,600-$174,400: 28%; etc.).
During the Clinton years, the highest tax bracket was 39.6%. Bush came into office and signed huge tax breaks into law. Tax cuts might seem like a nice thing in theory. But when the country has two wars to pay for, rising healthcare costs, a crumbling infrastructure, a baby boomer generation that will soon need Social Security and Medicare to retire with dignity, something has to give. The real question—the answer to which supplies a stark contrast between Romney and Obama—is whether we want to balance the budget on the backs of the middle class and the elderly (Romney’s plan), or require the richest among us (top 2%) to pay more (Obama’s and Clinton’s plan).
The system of deductions and itemization is another complex aspect of our tax code. A deduction is quite different from a tax credit: a deduction reduces a taxpayer’s income from which he/she can be taxed, while a credit is a dollar-for-dollar reduction of the taxes one owes to the government (thus, a tax credit is worth a lot more). Essentially, there are two types of taxpayers: those who take the “standard deduction” and those who “itemize” their deductions. You can’t choose both (but if you don’t choose one, Uncle Sam will greatly appreciate it). The standard deduction for unmarried taxpayers is currently $5,800; married couples filing jointly may deduct $11,600. If you take the standard deduction route, you may deduct that amount ($5,800 or $11,600) from your adjusted gross income to determine what bracket you’re in, and hence, the amount of taxes you owe. On the other hand, it may be wiser to “itemize” your deductions in any given taxable year if, for example, you own a home (and pay a mortgage), pay state/local taxes, have high medical expenses, and/or make charitable donations. This is because the dollar amount of such expenses may exceed the standard deduction, and would thus allow the taxpayer to show a lower income for tax purposes.
On top of changing the tax bracket percentages, both campaigns are proposing to make reforms to some of the current deductions for itemizers. To be fair, neither campaign has provided a great deal of information on which reforms it will seek (likely because it will anger various constituencies). Romney has been less forthcoming, so much so that even Fox News has become impatient.
Reforming the system of deductions will affect the government’s revenue by billions of dollars. Basically, the government is subsidizing certain taxpayer expenses. Why? In the case of allowing deductions for mortgage interest on your principal residence, the idea is to incentivize people to become homeowners. Allowing deductions for charitable donations is supposed to encourage goodwill (turns out that a warm, fuzzy feeling sometimes isn’t enough). All of these subsidies come with a fat price tag. The deduction for home mortgage interest, which millions of itemizers take advantage of each year, costs the U.S. Treasury approximately $484 Billion. Deductions for state and local taxes cost the Treasury $237 Billion. Deductions for charitable donations will cost the government $315.1 Billion from 2011-2015. Many economists and tax policy experts find various deductions to be horribly inefficient and unfair.
A Floor For Deductions
To reduce the impact of deductions on the Treasury, the concept of a “floor” has been introduced in some circumstances. For example, in order to utilize the medical expense deduction, a taxpayer must first reach a 7.5% floor, or threshold. If the taxpayer has an adjusted gross income of 100K, he/she must have paid more than 7.5K (7.5% of 100K) in medical expenses in that year before he/she can use that deduction. The government does not subsidize the first $7,500, but will subsidize the amount above. To be clear, you still have to pay for the medical bills; the benefit is that you don’t have to pay tax on the income you received that went toward paying those medical bills.
The Deduction For Charitable Contributions
The U.S. Government permits deductions—up to 50% of an individual’s adjusted gross income—for gifts made to educational and medical institutions, churches, and certain publicly supported organizations. Economists have generally found that the “dollar efficiency” of the deduction is high. Hence, deductions incentivize donations, and most studies conclude that the dollar gain to the charitable organization equals, and even sometimes exceeds, the dollar loss to the Treasury. Despite the fact that studies have shown that charitable donations are responsive to changes in marginal tax rates, is the immense cost of the current deduction justifiable?
One Simple Solution
One policy change to reduce the cost to the Treasury (i.e. $315 Billion from 2011-2015), while retaining the incentive for charitable giving, would be to implement a floor like the one just described for medical expense deductions. For instance, Congress should make charitable donations deductible only to the extent that they exceed a certain floor (i.e. 3% of a taxpayer’s adjusted gross income). Such a change would not affect incentives to donate because of the structure of a floor. If we assume that Taxpayer (“T”) has an adjusted gross income of 100K, is subject to a marginal tax rate of 25%, and typically makes 10K in donations each year, under the new policy, T would be allowed a deduction of only 7K instead of 10K. The 3K that T was previously permitted to deduct would now be taxed, while the charities would still receive the full amount.
Here’s a real life example, from the recently released 2011 tax returns of Mitt Romney. Romney had a taxable income of $13,696,951 and donated $4,020,772 to charity in that year. Three percent of $13,696,951 is $410,908.53. If Congress had enacted a measly 3% floor for charitable donations, the Treasury would have been able to collect taxes(35%) on that money, while the amount he donated would have stayed the same. By allowing the current deduction of up to 50% of one’s adjusted gross income, without ANY floor, the U.S. Government is providing enormous (and unnecessary) hand-outs to the wealthy. Romney should follow his own advice and advocate against such “entitlements.”
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If we can maintain the charitable incentive while increasing funds for necessary government programs and paying off our nation’s debt, then I think a charitable deduction floor is a common sense policy proposal that most people, liberal and conservative, can agree on.
Thoughtful article, but I have to disagree with the major premise of your argument. Allowing individuals to keep more of their income is not the same thing as the government subsidizing taxpayer expenses. By that same logic, if I make $50,000 per year after taxes, then am I costing the federal government 50,000 in “revenue”? I prefer to look at these deductions as more incentive to donate. And who is to say the federal government should decide where to donate the money? How would they go about deciding which charities to donate to? Or would this plan ultimately cost the charities, and the American spirit of giving?
Justin Gordon says
Thanks for your comment. Allowing individuals to keep more of their income–income which the government has a legal right to collect taxes on but refrains from doing so–is considered “foregone revenue”.
Let’s say that there was no charitable donation deduction at all, but that the rest of the marginal rates remained the same. If you have an AGI of 100K and donate 10K to charity, you would still have to pay taxes on the 100K that you earned (including the 10K you donated). Thus, by providing itemizers with a deduction for charitable contributions, the Government is allowing you to keep some of the money to which the Treasury is actually entitled. This is the Government saying “your donation is worthy of us not collecting taxes on the amount that you donated so we will forego that money.” How is that not a subsidy? Personal expenditures are taxable (unless otherwise deductible under the Internal Revenue Code), so if you were going to donate the money anyway, you’d be getting your taxes subsidized by the Government. Even if you weren’t going to donate, you still get the benefit of having donated to a good cause as well as not having to pay taxes on the income you used to donate to that good cause.
Your example concerning earning 50K per year after taxes being a cost to the federal government in revenue does not logically follow the premise of my article. The government is not legally entitled to 100% of your income; if that were the case then taxes would have to be 100%. They aren’t even close to that.
I don’t disagree that these deductions are more of an incentive to donate. My argument is that having a 3% floor will not remove that incentive to donate, while still providing the federal government with some revenue. Also, the floor does not change the fact that the charities will receive the full amount of the donation. It’s arguable that people will donate more than they originally would have just so they can reach that 3% threshold before the deduction kicks in.
It’s not about “who is say that the federal government should decide where to donate the money.” The Government is not in the business of making donations (unless you consider all federal expenditures, like salaries for public employees, to be “donations”). Tax revenue collected by the Government is spent on thousands of different things (roads, schools, military, etc.). If the Government did not collect any taxes, but merely allowed individuals to donate however much they wanted to whichever causes they wanted, do you think that there would be enough funding for roads/bridges, schools, the military, etc.? The federal government is in a unique position to allocate resources to various agencies based on policy studies and level of need.
I guess in a way the federal government is subsidizing charities but definitely not the individuals. The individual is not saving money by donating but rather being taxed on less of his income. Whatever tax break he got was passed along to the charity.
Ultimately someone has to pay for this proposal and it would be the charities. Would individuals donate more if much of the financial incentive was taken away? Of course not, that is my point. You would end up with more non-profits having to shutter their doors. Would the federal government step in and fill the void? Perhaps, but do you really want them picking the winners and losers?
I don’t understand all the uproar about Mr. Romney’s tax returns. Please define what his fair share ought to be. I think that’s pretty darn good that he donated $4+ million to charity in one year. I’m also unsure of how by taxing him more, he will still be able to donate the same amount. The money has to come from somewhere.
Justin Gordon says
The federal government is definitely subsidizing charities too. Qualifying charities like churches don’t pay any taxes on the donations they receive, among other benefits.
When you say that the “individual is not saving money by donating but rather being taxed on less of his income”, I think you just proved my point. By being taxed on less of your income, you are SAVING money. People like Romney, who must donate 10% of their income to the Mormon Church, are getting a huge tax deduction, and are thus saving a lot of money that would otherwise go to the federal government. Even if you’re not required to give donations to charities, the government does not have to give you a charitable deduction if it didn’t want to.
Charitable donations are different from gifts to a friend or family member. When the gift is to a friend, the donor still has to pay taxes on the income he used to give that gift. The donee (the one receiving the gift) need not pay taxes on it; this is an instance where the tax benefit is passed along to the recipient. However, with charitable donations, neither the donor nor donee gets taxed! So there is a DOUBLE savings, both to the donor and donee (and, conversely, a double subsidy from the government).
If you’d like to read about the fairness of Romney’s tax rate and his charitable giving, here is an insightful article: http://www.thenation.com/blog/170105/romneys-ungenerous-donations
Also, did you know that Romney only deducted a portion of his charitable donations because he feared that his tax rate would be too low? He made a promise that he has never paid less than 13.66% in taxes, and taking the full deduction in 2011 would have broken that promise. Pretty interesting. Let’s see if he files an amended return to claim those extra deductions if he doesn’t become president. Oh wait, he’ll never release those, so we’ll never know!
Since we’re sending website links, here’s a non-profit AND an alternative to your left-leaning news sources. And they are discussing this very issue of Romney’s tax returns:
Mrs. Pop @ Planting Our Pennies says
Doesn’t the standard deduction already act somewhat as a floor, albeit a floor that is combined across many different types of deductions?
Last year, we did not have enough itemized deductions (of which charity is one) to surpass that floor, and so none of our charitable contributions were deductible. Would you support getting rid of the standard deduction and putting into place separate floors for each different type of deduction?
How about ceilings on deductions as well? I tend to be much more in favor of those.
Justin Gordon says
Thanks for your comment. You’re correct that the standard deduction already acts somewhat like a floor. The main reason we have a standard deduction is based on the policy goals of efficiency and ease of administration. 70% of taxpayers take the standard deduction. Calculating deductions is already quite burdensome for the 30% of taxpayers who itemize. Thus, I’m not in favor of getting rid of the standard deductions because if ALL taxpayers had to figure out their expenditures, it would make a complicated system even more burdensome! Plus, if the standard deduction had been removed, you would have had less of a deduction since the standard deduction was more beneficial to you than if you had been able to itemize.
There currently is a ceiling on charitable deductions–50% of one’s contribution base (i.e. AGI). I believe that the Obama campaign is proposing a 28% ceiling on charitable donations. It’s tough to say whether or not that would be more beneficial than a floor (or to combine it with a floor). We would need to look at data from economic studies to determine the pros/cons.
Miss T @ Prairie Eco-Thrifter says
I would have to agree with JY. The two really aren’t the same. Donations and how much should be up to the individual. The government can’t dictate that.
Justin Gordon says
The individual has the choice to donate nothing or as much as he/she wishes. The government is incentivizing donations by allowing individuals to deduct the amount that they donate from their income (i.e. as if they earned less in that taxable year). The Government reads your income tax statements as if you earned less (when in fact you donated some of your earnings, and should have been taxed on such earnings).
John S @ Frugal Rules says
I’d have to agree that a limit of charitable contributions is not the role of the government. If I want to donate 90% of my income to charity, then I should be free to do so. That being said, I do believe that there are other things in the tax code that should be changed or gotten rid of altogether. The tax code in and of itself is a terribly huge boondoggle that needs changed. Of course, getting the two sides in Congress to agree how to do so is the hard part.
Justin Gordon says
The government does not limit you from donating all of your savings to charity; you are free to donate your house to your favorite church.
However, it is absolutely the government’s role to limit charitable contributions from your taxable income each year. If everyone wanted to donate 90% of their income to charity then the government would not have enough revenue to support a military, pay for Social Security/Medicare, build roads, etc. The 50% contribution limit for each taxable year is meant to strike a balance between personal donations and tax revenue to keep the government running. That said, you are free to quit your job and volunteer for your favorite charity full-time!
Thanks for the comment.
[email protected] says
“All of these subsidies come with a fat price tag. The deduction for home mortgage interest, which millions of itemizers take advantage of each year, costs the U.S. Treasury approximately $484 Billion. Deductions for state and local taxes cost the Treasury $237 Billion. Deductions for charitable donations will cost the government $315.1 Billion from 2011-2015. Many economists and tax policy experts find various deductions to be horribly inefficient and unfair.”
It doesn’t actually cost the Gov’t the figures you are quoting. The money I save in taxes is most often either spent elsewhere (generating sales tax and revenue that is taxed) or donated. In the case of the donations, most of the money generates revenue or income for other people, which again is taxed.
And yes, some of it is saved for retirement. Which again will be spent at some point generating revenue for someone that generates taxes.
The Gov’t does not have a tax problem. They have a spending problem. It is time for some serious cuts before an increase in taxes.
Most people find the Gov’t to be beyond horribly inefficient. And on any given day, probably at least 50% of the people find the Gov’t to not be fair. :O)
Justin Gordon says
I would have to disagree. Those are the facts on how much the U.S. Treasury is losing in revenue. Sales taxes go to the state treasury, not the federal government. When you donate to whatever cause, that doesn’t go to the federal government either because charities are tax-exempt.
When you say that your money “will be spent AT SOME POINT”, it doesn’t help the federal government for its current fiscal budget.
What would you propose we cut? How about education? Let’s have fewer teachers, more crowded classrooms, less books, and keep falling behind Japan, Korea, China, etc. as they keep raising the brightest students in the world. If there is a place to cut funding, its the military. Two unnecessary wars wasted over a Trillion dollars. Let’s bring those troops home and use funds for Veterans’ Services.
I like the article, and the author is obviously intelligent and knowledgeable. But, this sentence baffles me: “But when the country has two wars to pay for, rising healthcare costs, a crumbling infrastructure, a baby boomer generation that will soon need Social Security and Medicare to retire with dignity, something has to give.”
“Retire with dignity” would mean, to me, retiring on one’s own savings. I know the common argument is that they paid into the system, and therefore are due their benefits. However, they pay in much less than they receive in terms of purchasing power, and the money they pay in isn’t locked in a piggy banks: it’s immediately spent by Congress. “But the program is solvent til 2036!” No, it’s not. The “money” in the SS fund is in the form of treasuries. The government would have to sell those to get the money back. It’s like the government wrote itself a check for a million dollars, lent it to itself, spent it, and then claimed to still have the million dollar check on hand because the money is going to be paid back. It’s economic nonsense. I’m not saying we should rip the carpet out from people who are dependent on SS, but our country should be weaned off of it.
Medicare shouldn’t exist. It should simply be lumped in with a largely reformed Medicaid. If an elderly person can afford their healthcare (and that includes the value of their assets), why should we, the tax payers, be paying for it? Again, the carpet shouldn’t be ripped out. But Medicare incentivizes overconsumption and not getting health insurance. Maybe you shouldn’t buy that TV, or those cats, or that second home, and instead you should take care of yourself by buying health insurance. It’s bankrupting the economy because people use it as a safety net.
Why are healthcare costs rising? If you understand taxes, it should be clear! Payroll and income taxes favor a third party payer, specifically an employer-based third party payer system. Both my employer and I can deduct healthcare insurance premiums from our taxable base. So, it’s better financially, to get insurance through my employer. Also, with insurance companies forced to cover everything from a check up to an MRI, there’s no price sensitivity on the part of the consumers. When was the last time you checked the price for the X-ray that you needed? Sure, high deductible plans mitigate this a bit, but not enough. Insurance shouldn’t pay for routine things like checkups, Xrays, etc. no more than your car insurance should pay for oil changes. You know you’re going to need those services. Paying through an insurance company just adds on the cost of a middle man.
As for the wars, is the Department of Defense now the world’s most glaring misnomer?
If you read about the history of the income tax, you’ll see that it is unconstitutional to begin with.
I agree, that the entire tax code should be revised. We should be taxing spending, not income (which hilariously enough, isn’t even defined in the tax code!). There should be very few deductions, if any. This would free up the labro and capital that is wasted on accountants etc. in order to game the tax code.
I just did a post on how the mortgage interest deduction doesn’t help homeowners or the middle class. Sorry for leaving the link, but it seems to be relevant here. http://www.healthynwealthy.org/2012/10/the-mortgage-interest-deduction-cui-bono.html
Spot On says
Thank you for this excellent comment! It’s about time that somebody answered this socialist redistribution propaganda.
Some of the Government policies are un-understable and this is one of that. If Government wants to give a Tax break then give it to them who have needed it.
Harry Campbell says
Hi Rosey, thanks for stopping by. As Matt stated above, I think the mortgage interest deduction is one of the dumbest deductions on the US tax code. What type of people can afford a mortgage up to $1 million? Not the average taxpayer like me(and maybe you??).
My mortgage interest deduction is $7k haha, barely above the standard deduction. There are a couple good planet money podcasts you can google or I can look up for you if you’re interested. Just let me know!