In a new paper yesterday, we showed how policymakers could raise revenue exclusively from higher earners without increasing rates. Specifically, we showed three models which would phase in different types of tax expenditures caps on income above $200,000 ($250,000 for households) in a way that raised revenue similar to what would be generated by allowing the upper-income tax cuts to expire. Those models included a cap on itemized deductions, a percent of income cap on tax expenditure benefits, and a 28 percent rate limitation on deductions and exclusions that is phased down to zero as income rises to $1 million.
One common concern about this type of limitation is that they might hurt charitable giving by taking away the marginal tax benefits of giving. For example, if itemized deductions were capped at $25,000 and an individual had $30,000 of state and local taxes and mortgage interest, then they would have no tax benefit for charitable contributions. Of course, the charitable deduction isn't the primary reason individuals give to charity, and much of the cost of the deduction is to subsidize what individuals would have given anyway rather than incentivize new giving. Still, policymakers may want to think through ways to deal with the charitable deduction on a special track in order to maintain some incentive for giving.
- Remove the Charitable Deduction from the Limitations and Tighten the Limits: The simplest way to protect charitable giving from the caps in our paper would be to simply exclude it from any limitation. Of course, this approach by itself would result in a lot less revenue being raised. As an example, the Tax Policy Center recently found that excluding the charitable deduction from a dollar cap on itemized deductions would reduce the revenue raised by about one third. To recover some of that revenue, the overall caps could be tightened. As an example, it might make sense to reduce a $25,000 cap on all itemized deductions to a $20,000 cap on itemized deductions other than for charitable giving.
- Convert the Deduction Into a Credit: Rather than completely exempting the charitable deduction from any changes, an alternative approach would be to deal with it on a separate track. For example, the current itemized deduction for charitable giving could be eliminated, and in its place a percentage credit could be given. Replacing the deduction with a 15 percent credit would raise roughly $200 billion while actually reducing taxes on those with income below $100,000. A credit of about 20 percent would probably protect those making below $200,000/$250,000 from a tax increase on average. We've written recently on how such a credit could be designed to best promote charitable giving. Importantly, this change could be combined with a tightening of the broader tax expenditure limit.
- Credit for Contributions Above the Cap: Two of the broad limitations we suggested would put a hard cap on certain tax expenditures. Rather than replace the whole charitable deduction with a credit, an alternative approach would be to offer a credit only on charitable giving above the cap. For example, if a taxpayer gave $10,000 to charity but had $20,000 of other deductions and faced a $25,000 cap, they could be given a 15 percent credit for their last $5,000 of charitable giving. This would allow some marginal incentive for giving to continue, but at a lower cost.
- Limit the Phase-Out: One of the broad limitations we suggested would limit the rate-value where a deduction could be taken and then phase that value down as income rose. Specifically, those in the 35% bracket would only be able to take deductions as if they were in the 28% bracket, and that 28% number would gradually phase down to 0% for income above $1 million. To protect an incentive for charitable giving, the limitation could be held at 28% for that deduction; or could be allowed to fall to no lower than, say, 15%.
In short, there are a number of ways to address the concern of hitting charitable deductions with a broad-based tax expenditure limitation. Of course, there are trade-offs on revenue and progressivity that must be considered in doing these alterations. In any case, there are enough ways to create incentives for charitable giving that it should not rule out proposals to cap or limit the value of deductions among high income earners.