Do Itemized Deductions Make Sense?

Whatever policy justified the introduction of itemized deductions 82 years ago has long since been eclipsed.

I started to title this piece “Do Itemized Deductions Make Sense Anymore?” But the thought immediately occurred: did the concept of itemized deductions make sense? It may have, back in 1944, when it was introduced. Maybe I’ll take a harder look at that one day. On the surface, I don’t see why it would have.

Currently, though, I have trouble making sense of the system. Taxpayers either can claim the standard deduction, $16,100 for a single person and $32,200 for a married couple, or claim all the itemized deductions for which they qualify. There are many of them. The bulk of the action is in three categories: state and local taxes, mortgage interest, and charitable contributions, but that doesn’t make the other categories insignificant.

I understand the concept behind the standard deduction serving as an alternative to itemized deductions. But it doesn’t work that way in operation. Instead, it serves as a zero bracket amount. A single person with an income of $16,100 doesn’t have even a fraction of that amount in itemized deductions. The standard deduction doesn’t cover the state tax payments or charitable contributions of taxpayers at that level, it covers their food and clothing expenses.

Should the standard deduction—the zero bracket amount—be phased out as we move up the income scale? Yes, but that’s a subject for another post. Under the current system, the treatment of itemized deductions operates as a scattershot method of phasing out the benefit of the standard deduction. On balance, it’s not a rational approach. Here’s why:

For any given itemized deduction, there is a policy basis supporting it. Congress, however, has decided that policy basis is sufficient to justify an income tax benefit only to the extent other itemized deductions are substantial. For example, if a single person pays $16,000 of mortgage interest, the itemized deduction is worthless to him if it’s his only itemized deduction. But if he also paid $10,000 in state tax and gave $6,100 to charity, that mortgage interest deduction acquires value for tax purposes. If he then paid off the mortgage, however, those state tax payments and charitable contributions would lose their value for tax purposes.

It mystifies me that the tax benefit from my charitable contributions should depend on how much mortgage debt I happen to be carrying. What policy goal does that possibly serve?

The annual accounting for tax filing purposes makes itemized deduction even more arbitrary. You may get a better tax result, for example, if you can make 5 years’ worth of charitable contributions all in one year. Since that typically would mean saving for five years before contributing, the charity does worse.

As I go through the list of itemized deductions, I find that each item falls into one of three categories: (1) itemized deductions that should be allowed as so-called “above-the-line” deductions (that is, deductions allowed in computing adjusted gross income); (2) deductions that should instead be the basis for a tax credit, or (3) deductions that should be considered to be covered by the standard deduction (or, really, zero bracket amount) and not allowed as separate deductions. Which means the entire program of itemized deductions is unnecessary. The individual deductions could be treated as I’ve outlined above.

For an example of the first category, consider the treatment of gambling losses. The deduction for gambling losses is approximately limited to the amount of a taxpayer’s income from gambling winnings. A second limitation, from Trump’s OBBBA, is less rational: only 90 percent of gambling losses are deductible. The purpose of that limitation seemingly was to nick a few powerless average taxpayers to offset .001 percent of the revenue lost to Trump’s giveaway to billionaires. As ugly as that is, there’s a third—and worse—limitation that’s been around for decades. A taxpayer may not claim any deduction at all unless she itemizes deductions. Here’s how that plays out:

Three taxpayers, Jane Jill, and Jenna, all hit the casino one night and each is $9,000 ahead. Jane and Jill call it a night, while Jenna stays at the casino and proceeds to lose her winnings, plus another $1,000. A few nights later, Jane and Jill hit the casino again and each loses $10,000. So, overall, Jane, Jill and Jenna had the same result, but their tax treatment is completely different.

Jenna has the easiest situation to report. Since she never left the casino with more money than she started with, nothing goes on her tax return. Jane and Jill each has $9,000 of gambling winnings to report, and each is eligible to claim a $9,000 itemized deduction, the amount of her earlier winnings. [I rigged the numbers to sidestep Trump’s new 90 percent limitation]. But Jane and Jill’s other tax attributes differ. Jane earns $90,000 as a cop, rents her apartment, and makes only modest charitable contributions. Her other itemized deductions total far below the $16,100 standard deduction. The $9,000 itemized deduction for her gambling losses increases her total itemized deductions to $14,000, so she’s still better off claiming the standard deduction. Her gambling losses didn’t reduce her taxable income, but her gambling winnings increased it.

Jill is a successful investment banker. The interest on her $700,000 mortgage, her deductible state and local taxes, and her charitable contributions total $25,000. Her $9,000 itemized deduction for her gambling losses increases her total itemized deductions, thus offsetting the $9,000 income increase from her gambling winnings.

The end result? Our three unlucky gamblers each lost $1,000 overall, but one, Jane, is particularly unlucky. She must pay tax on $9,000 of what really is fictional gambling income. The only difference between her and Jill is that she doesn’t pay mortgage interest and higher state taxes. In this respect, the federal income tax is absurdly regressive. High income taxpayers who typically itemized deductions can effectively deduct modest gambling losses against gambling winnings. Average taxpayers who typically claim the standard deduction can’t.

The difference in tax treatment between Jane and Jenna is equally absurd. The only difference in their gambling activities is that Jane took a break between winning and losing at the casino. On what planet should that make for a difference in tax treatment?

The solution here is to treat gambling losses as an above-the-line deduction, subject to the limitation that the deduction can’t exceed gambling income. That would equalize the tax result for our three equally unlucky gamblers.

Many other itemized deductions fall into this category, including, I think, state and local income tax. State and local income tax is an unavoidable expense in producing income. In my opinion, it’s a policy mistake to charge federal income tax on income a taxpayer has no choice but to pay to the state government. But even if the deduction should be limited, the same limitation should apply to all taxpayers.

The big item I’d place in the second category is charitable contributions. The policy of conferring a tax benefit for charitable contributions only on those taxpayers with substantial itemized deductions is regressive in two ways. First, it leaves most average taxpayers with no tax benefit, since they typically don’t itemize deductions. Second, even those average taxpayers who do itemize benefit proportionately less because the deduction reduces income in a lower tax bracket. A worker struggling to pay basic expenses on a $50,000 income might see a $12 tax reduction from making a $100 charitable contribution. But a millionaire making that same $100 contribution would net a $35 tax reduction. Why?

The better approach would be to allow a credit against income tax equal to an agreed upon percentage of charitable contributions.

An example for the third category would be property tax payments. Anyone who pays for their housing pays property taxes. Tenants don’t pay property taxes directly, but every dollar of property tax their landlords pay is passed through to them as rent. In this sense, property taxes are a basic living expense. They should be considered covered by the standard deduction. And property taxes above the level that would be covered by the standard deduction should be considered a personal expense. Currently, ultra-rich, high-income taxpayers may derive a federal income tax benefit from property taxes paid on their mega-mansions. That’s a poor policy choice.

Would these changes complicate tax filing for low and middle income taxpayers? Yes, but not very much. There would be a line item for charitable contributions, but that already exists for small contributions. There would be a line item for state and local income tax. And there might be a schedule for other deductions, but few low and middle income taxpayers would need to complete that schedule.

I’ll end where I started. Whatever policy basis supported itemized deductions when they first were introduced has been eclipsed over the years by an increasingly arbitrary set of rules giving rise to obviously unfair outcomes. Those arbitrary rules largely evolved from a perceived need for revenue to offset giveaways in tax bills over the years. (For a shining example of this, consider the Pease limitation, which evolved this year into the “2/37 limitation.)

Effectively, itemized deductions have become a piggy bank for tax writers to improve the revenue scores of otherwise costly tax bills. It brings to mind the old philosophy of taxation: “Don’t tax me; don’t tax thee; tax that guy behind the tree.” Remember our small-time gamblers, Jane, Jill and Jenna? They’re that guy behind the tree.

Could the arbitrariness be removed and the fairness of the itemized deduction system salvaged? Perhaps, but why bother? The tax code would work better without it.

[Note to readers: The treatment of housing related expenses obviously connects to this. I’ve touched on it here, but I’m hoping to cover it more comprehensively in a coming post.]