Would a 28% Limit on Itemized Deductions be Fair?

Posted by Jeffrey Brown on Jul 11, 2011

Filed Under (U.S. Fiscal Policy)

About two weeks ago, I was contacted by a company that was interested in talking to me for 30 minutes about what information I found valuable as a member of an Audit Committee for a large corporate board.  Their creative (and effective) approach to getting me to take 30 minutes out of my busy schedule to talk to them was to offer to make a $300 charitable donation to any charity of my choosing.  Because I am currently volunteering on a capital campaign to help a local non-profit institution undertake a major capital project, I figured this was a worthwhile effort.  I could help this organization deliver better information to board members, and my favorite non-profit would benefit financially. 

There are two ways to treat this transaction on my taxes.  First – which is the easy route which I suspect most people take – would be to simply ignore this transaction on my taxes, with the rationale being that I received no money.  The second way (and the one that may be the technically correct way to do it – but I will have to check with my accountant!) is to report it as $300 of taxable income, and then also report a $300 tax deductible contribution to the non-profit.  Either way, my tax liability is unchanged by having spent 30 minutes doing this – the charitable deduction exactly offsets any income.

But if the Obama Administration and Congressional Democrats have their way, and if I were to perform such a civic act in the future, I would owe about $21 in taxes on this transaction, even though I never received a penny.  Why?

As reported in the July 5 Wall Street Journal article by John McKinnon and Carol Lee, Democrats would like to impose a cap on the value of itemized deductions.  Instead of allowing me to offset my income at my 35% marginal tax rate, they would cap it at 28%.  So, now, I would pay a 35% tax on the $300, and then only get to deduct 28% of $300.  Thus, I pay the difference (7% of $300) in taxes, even though I never saw the money.

Is this fair? 

The main point I want to make with this blog is that “fairness” is not a well-defined economic concept.  It does seem “unfair” to me that I may now have to send the government another $21 just because I decided to do spend 30 minutes helping out these two organizations, even though I did not personally profit from it.  Interestingly, however, the Democrats are justifying this policy solely on the basis of “fairness.”  As the WSJ article states: “Democrats argue that high-income people unfairly benefit from any given tax deduction now more than middle-class people do, just because they are in higher tax brackets.”

I find the Democrats’ position is a difficult one.  We have a progressive tax system that imposes higher marginal tax rates on higher incomes.  Basically, the rich pay more, on average.  So then we decide – for reasons that may be the subject of a future post – that some activities (such as charitable contributions) should be tax deductible.  But then we argue that it is not fair to give a tax deduction to the high earners because they “benefit” more.  But the only reason they “benefit” more from the tax deduction is because we have imposed a higher tax on them to begin with!  So in the name of fairness, we levy higher taxes on the rich, and then in the name of fairness we complain about its implications?

My bottomline is that “fairness” is not actually a well-defined concept.  It is also not a topic on which the economics profession has any comparative advantage in addressing.  We are much better at understanding the impact of policy on incentives, and even on how a policy affects resource distribution (a topic which is presumably related to many concepts of fairness).  So I am always a bit wary when people make unequivocal statements about fairness to justify a policy. 

My treatment of this topic is, admittedly, quite incomplete.  Among the issues I have not addressed, but may in future posts:   1) Is it desirable to allow tax deductions for certain activities at all?  2) Do we think we have too much or too little in the way of charitable giving?  3) What impact would such a policy have on the charities that rely on voluntary donations?  Stay tuned …