Eliminate or Limit Itemized Deductions

Background

When preparing their income tax returns, taxpayers may choose to take the standard deduction—a flat dollar amount—or to itemize and deduct certain expenses, such as state and local taxes, mortgage interest, charitable contributions, and some medical expenses. Deductions reduce the amount of income subject to taxation (taxable income). Taxpayers benefit from itemizing when the value of their deductions exceeds the amount of the standard deduction. For calendar year 2022, the basic standard deduction amount ranges from $12,950 for a single filer to $25,900 for a married couple filing jointly, with additional amounts allowed for taxpayers who are age 65 or older or blind.

The change in taxes from deductions depends on the taxpayer's marginal tax rate (the percentage of an additional dollar of income that is paid in taxes). For instance, $10,000 in deductions reduces tax liability by $1,200 for someone in the 12 percent tax bracket and by $2,400 for someone in the 24 percent tax bracket.

Because deductions reduce the cost of incurring certain expenses, they serve as subsidies for undertaking deductible activities. Most of the tax savings from itemized deductions constitute a tax expenditure for the federal government. (Tax expenditures are exclusions, deductions, preferential rates, deferrals, and credits in the tax system that resemble federal spending in that they provide financial assistance for specific activities, entities, or groups of people.)

The tax code imposes several limits on the amount of itemized deductions that taxpayers can claim. Currently, taxpayers cannot deduct more than $10,000 in state and local taxes, nor can they deduct home mortgage interest on loan amounts over $750,000. For some types of expenses, such as medical expenses, only the amount that exceeds a certain percentage of the taxpayer's adjusted gross income (AGI) can be deducted. (AGI consists of income from all sources not specifically excluded by the tax code, minus certain deductions.) The alternative minimum tax (AMT), which acts as a parallel tax system, also serves as a limit on itemized deductions by disallowing some and restricting others. The AMT does not currently affect many taxpayers, but the Congressional Budget Office projects that, once changes put into effect by the 2017 tax act (Public Law 115-97) expire at the end of calendar year 2025, the AMT will affect more than 7 million taxpayers.

Many of the tax rules relating to itemized deductions were also affected by the 2017 tax act and, like those affecting the AMT, are scheduled to expire at the end of 2025. The standard deduction will be reduced by roughly 50 percent, making itemization beneficial for more taxpayers. In addition, several restrictions on deductions that were put in place by the act will no longer be in effect. The limit on state and local taxes will be removed, and the limit on mortgage interest will revert to the higher aggregate loan amount ($1.1 million) set by pre-2018 tax law. Furthermore, several itemized deductions that were temporarily eliminated by the 2017 tax act will be reinstated, including the deductions for unreimbursed employee expenses and tax preparation fees. Finally, a provision that reduces the overall value of certain itemized deductions will be restored for taxpayers whose AGI exceeds a specified threshold. That limit, originally proposed over 30 years ago by Congressman Donald J. Pease and often called the Pease limitation, can reduce those itemized deductions by up to 80 percent, depending on the taxpayer's income. The net effect of the expiration of those provisions will be to increase the number of taxpayers who itemize and the amount of deductions they claim. Because most statutory tax rates will increase when the 2017 tax act expires, the tax benefit of itemized deductions will also generally increase in 2026.

In calendar year 2017 (before the 2017 tax act took effect), taxpayers claimed itemized deductions on almost 47 million tax returns, according to the Internal Revenue Service. Those itemized deductions totaled $1.4 trillion. By comparison, if the taxpayers who filed those returns had claimed the standard deduction instead, their deductions would have totaled $475 billion, and aggregate taxable income would have been about $925 billion higher. Put another way, those taxpayers collectively received $925 billion more in deductions than they would have received if they had been required to claim the standard deduction.

Because the 2017 tax act nearly doubled the amount of the standard deduction and placed new limits on itemized deductions, taxpayers claimed itemized deductions on fewer than 18 million tax returns in calendar year 2019; those itemized deductions totaled $645 billion. If the taxpayers who filed those returns had claimed the standard deduction instead, then aggregate taxable income would have been $325 billion higher.

Option

This option consists of four alternatives, each of which would take effect in January 2023.

• Under the first alternative, all itemized deductions would be eliminated. As a result, taxpayers who would otherwise itemize deductions would have to claim the standard deduction, which generally would be of less value to them.
• Under the second alternative, the itemized deduction for state and local taxes would be eliminated. Because most taxpayers who itemize deductions pay state and local taxes, this alternative would effectively reduce deductions for almost all itemizers and cause some of them to claim the standard deduction instead.
• Under the third alternative, the tax benefit of itemized deductions would be limited to 15 percent of their total value. As a result, taxpayers in tax brackets with statutory rates above 15 percent would generally receive less benefit from itemized deductions than under current law, whereas taxpayers in tax brackets with statutory rates that are equal to or less than 15 percent would be unaffected by the change. The Pease limitation would also be permanently removed.
• Under the fourth alternative, the tax benefit of itemized deductions would be limited to 4 percent of a taxpayer's AGI. As a result, taxpayers whose savings from itemized deductions exceeded 4 percent of their AGI would receive less benefit from itemized deductions than under current law, whereas taxpayers whose savings from itemized deductions equaled 4 percent or less of their AGI would be unaffected by the change. The Pease limitation would also be permanently removed.

Taxpayers who claim the standard deduction under current law would be unaffected by any of the four alternatives.

Effects on the Budget

The staff of the Joint Committee on Taxation (JCT) estimates that, from 2023 to 2032, the four alternatives would have the following effects:

• Eliminating all itemized deductions would reduce the deficit by $2.5 trillion;
• Eliminating the deduction for state and local taxes would reduce the deficit by $1.1 trillion;
• Limiting the tax benefit of itemized deductions to 15 percent of their total value would reduce the deficit by $1.4 trillion; and
• Limiting the tax benefit of itemized deductions to 4 percent of AGI would reduce the deficit by $0.5 trillion.

Under all four alternatives, the amount of additional revenues would rise sharply after 2025 when most changes to the individual income tax system that were put in place by the 2017 tax act will expire. That increase in revenues would occur for two reasons. First, the expiration of certain provisions of the act will substantially increase the number of taxpayers who itemize and the amount of deductions they claim. Consequently, the increase in revenues from eliminating deductions would be much larger in later years. Second, statutory tax rates are scheduled to increase after 2025. Because those higher rates will increase the tax benefit of itemized deductions, the revenues raised from the four alternatives would increase as well.

The estimates of the budgetary effects of this option incorporate anticipated reductions in spending by taxpayers on activities that currently qualify as itemized deductions. The degree to which those reductions in spending would affect tax revenues varies among the alternatives. Eliminating all itemized deductions—the first alternative—would remove the tax incentives for taxpayers to spend on deductible items. However, the estimate for that alternative is not sensitive to the resulting reductions in spending on deductible items because all taxpayers would be required to take the standard deduction.

In contrast, eliminating only the itemized deduction for state and local taxes—the second alternative—would reduce the incentive for some taxpayers to spend money on other deductible items, such as mortgage interest and charitable contributions. With fewer allowable itemized deductions, some of the affected taxpayers would no longer benefit from itemizing and would take the standard deduction instead. As a result, they might spend less on other deductible items, but those reductions would not affect their tax liability further. Other affected taxpayers might continue to itemize but would also choose to reduce their spending on other deductible items; that response would affect tax revenues. For example, the increase in housing costs from the loss of the property tax deduction might cause people to purchase less expensive homes, thereby reducing their spending on mortgage interest. That reduction would further decrease their itemized deductions and increase their tax liability, perhaps causing them to choose the standard deduction.

Limiting the tax benefit of deductions to 15 percent of their total value—the third alternative—would reduce the incentive for taxpayers with a top statutory tax rate above 15 percent to spend on deductible items. Affected taxpayers would continue to receive a tax benefit from each additional dollar spent on tax-deductible items, but the tax benefit of each dollar would be less than under current law. This reduction would cause some of those taxpayers to spend less than they currently do on deductible items, an effect that would increase tax revenues.

Limiting the tax benefit of itemized deductions to 4 percent of AGI—the fourth alternative—would eliminate certain taxpayers' incentive to spend more on deductible items because they would not receive any tax benefit for each additional dollar spent above the threshold. Taxpayers who currently receive a tax benefit of more than 4 percent of their AGI from deductible items might reduce that spending because of the reduced tax benefit. However, that reduced spending would not affect revenues unless the reduction caused the tax benefit of the itemized deductions to drop below 4 percent of AGI.

Uncertainty About the Budgetary Effects

The estimated decreases in the deficit from these alternatives are uncertain because both the underlying projection of itemized deductions and the estimated response to the change in the tax treatment of those deductions are uncertain. Projections of spending on deductible items are inherently uncertain because they are based on CBO's projections of the economy over the next decade. That uncertainty is compounded because the projections reflect the effects of the scheduled expiration of many provisions of the 2017 tax act, which are also uncertain. Furthermore, the estimates rely on expectations of how taxpayers would change their behavior in response to changes in the tax treatment of itemized deductions. Those expectations are based on observed responses to past changes, which might differ from the responses to the tax changes considered here. Those behavioral uncertainties are less important for the first alternative, which would eliminate all itemized deductions, and for the fourth alternative, which would limit the tax benefit of itemized deductions to 4 percent of a taxpayer's AGI. That is because reductions in spending on deductible activities would not significantly affect tax revenues under those alternatives.

An additional source of uncertainty is how state and local governments would react to the various alternatives. Many states have changed their tax systems in response to the $10,000 limit on state and local tax deductions to allow certain taxpayers, such as small business owners, to avoid that limit. Such actions by states could increase under this option.

Distributional Effects

Itemized deductions benefit higher-income households more than lower-income households for two reasons: Higher-income households incur more expenses that can be deducted, which makes them more likely to itemize; and the per-dollar tax benefit of those deductions depends on the taxpayer's marginal tax rate, which rises with income. For example, CBO estimates that in calendar year 2019, more than 75 percent of the tax expenditure for state and local taxes accrued to households with income in the highest quintile (or one-fifth) of the income distribution (11 percent went to households in the top 1 percent). As a result, eliminating or limiting itemized deductions would increase average tax rates—and therefore decrease average after-tax income—more for higher-income households than for lower-income households. Limiting the tax benefit of itemized deductions to 15 percent of their total value (the third alterative) would make the tax benefit more uniform across the income distribution by reducing the tax benefit of deductions for higher-income households while leaving the tax benefit for lower-income itemizers unchanged. Limiting the tax value of itemized deductions to 4 percent of a taxpayer's AGI (the fourth alternative) would increase taxes on itemizers throughout the income distribution because some lower-income households would have deductions that represent a large percentage of their income.

Economic Effects

In addition to having the behavioral effects reflected in conventional budget estimates, such as the ones shown above, changing the availability of itemized deductions could affect the decisions that taxpayers who itemize make about how much to work, save, and invest. Eliminating or limiting itemized deductions would, in effect, increase the marginal tax rate faced by taxpayers who itemize because, most likely, some portion of their additional earnings would be spent on deductible items. When marginal tax rates increase, people have an incentive to work fewer hours because other uses of their time become relatively more attractive. Increases in marginal tax rates can also cause people to work more hours, because having less after-tax income requires additional work to maintain the same standard of living. CBO estimates that, on balance, the former effect would be greater than the latter effect.

Eliminating all itemized deductions, the first alternative, would have the largest effects on aggregate hours worked. Eliminating only state and local tax deductions, the second alternative, would have similar effects on the supply of labor for taxpayers whose itemized deductions—excluding state and local taxes—were smaller than the standard deduction and who, as a result, would take the standard deduction. For those taxpayers who still itemized deductions after the elimination of the deduction for state and local taxes, the second alternative would have a smaller effect on their decisions about how much to work than the first alternative. That is because they would continue to receive a tax benefit for some of their new spending on deductible items.

Limiting the tax benefit of itemized deductions to 15 percent of their total value, the third alternative, would lead to smaller labor supply effects than the first alternative because only taxpayers with marginal tax rates in excess of 15 percent would be affected, and those people who were affected would still receive a tax benefit of 15 percent on each additional dollar spent on deductible items. Limiting the tax benefit of itemized deductions to 4 percent of AGI, the fourth alternative, could cause taxpayers affected by the AGI limit to change the number of hours they work (much as the first alternative would) because each additional dollar spent on deductible items would result in no additional tax benefit. Taxpayers unaffected by the AGI limit would not change the amount of labor they supplied.

By encouraging spending on deductible activities, itemized deductions affect saving and investment decisions and can lead people to over-invest in certain deductible activities at the expense of other more productive activities, which could act as a persistent drag on economic growth. For example, the mortgage interest deduction distorts the housing market by encouraging people to take out larger mortgages and buy more expensive homes, which pushes up housing prices. That leads people to invest more in housing, relative to other more productive assets, than they would if such investments were taxed more equally. Additionally, the deduction for state and local taxes encourages state and local governments to raise taxes and provide more services than they otherwise would if such taxes were not deductible (although some research indicates that total spending by state and local governments is not sensitive to that incentive).

Changing itemized deductions could also significantly disrupt the housing market. Eliminating or limiting the deduction for mortgage interest and property taxes would both increase the cost of owning a home and reduce the price new homebuyers would be willing to pay, thereby reducing the housing wealth of current homeowners. Both effects would cause current homeowners to reduce spending on goods not related to housing, which could act as a temporary drag on economic growth until the housing market fully adjusted. That is particularly true for the first alternative, which would eliminate all itemized deductions, although there could be similar responses to the second alternative, which would eliminate the deduction for state and local taxes, thus affecting property taxes. Changes to the mortgage interest deduction and the state and local tax deduction made by the 2017 tax act probably had such effects.

Other Considerations

Eliminating or limiting itemized deductions would result in reduced spending on deductible activities. Certain itemized deductions, such as charitable contributions, can have widespread benefits for society. Reducing the incentive to spend on those types of activities could worsen the allocation of resources. However, eliminating or limiting taxpayers' incentive to spend on deductible activities that primarily benefit those taxpayers—such as taxes that support certain types of state and local government spending—could improve the allocation of resources. That is because taxpayers would make decisions about spending on the basis of the benefit they derive from the specified good or service, rather than on the basis of tax considerations.

Allowing certain itemized deductions yields a measure of taxable income that more accurately reflects a person's ability to pay taxes. For example, taxpayers with high medical expenses, casualty and theft losses, or state and local taxes have fewer resources available for paying federal taxes than taxpayers with the same amount of income and smaller expenses or losses (all else being equal). However, if taxpayers directly benefited from the goods and services funded by state and local taxes, concerns about the ability to pay those taxes would be lessened.

Allowing itemized deductions yields a more accurate measure of net income in some other situations. The deduction for payments of interest on money borrowed to purchase taxable investments, known as the investment interest expense deduction, allows people to subtract the costs they incur to earn the income that is being taxed (in much the same way that businesses are allowed to deduct expenses from revenues). Under the alternatives presented here, the ability of taxpayers to subtract such expenses from their taxable income would be eliminated or limited, even though the expense was necessary to generate income that is subject to taxation.

Finally, to itemize deductions, taxpayers must keep records of their deductible expenses and enumerate them on their tax form. Eliminating itemized deductions would therefore simplify the process of filing tax returns.