The Fiscal Cliff Deal Does Not Limit Itemized Deductions

January 22, 2013

Contrary to media reports claiming the fiscal cliff deal discourages charitable giving, the new fiscal cliff deal does not actually cap any itemized deductions. It's easy to see why people might think otherwise. The new law brings back to life a provision - in effect from 1991 through 2009, but lapsed from 2010 through 2012 - that Congress calls the "overall limitation on itemized deductions." But, the name is a misnomer.  For nearly everyone who is subject to it, the resurrected provision has no economic link to itemized deductions and doesn't change the tax savings from giving more to charity, says Alan Viard, a resident scholar at the American Enterprise Institute.

The provision is called the Pease provision after its author, former Congressman Donald Pease (D-Ohio).

  • The Pease provision adds an extra amount, 3 percent, to any income a taxpayer earns that exceeds a threshold.
  • The threshold is set at $300,000 for married couples in the fiscal cliff deal.
  • So consider, for a couple making $400,000, 3 percent of the excess income, or $3,000, would be added to their taxable amount. If the couple was in the 39.6 percent tax bracket, they would pay $1,188 more in taxes.

In this example, the $3,000 is added to the taxable income by subtracting $3,000 from the itemized deductions the couple would claim. The provision does not change a taxpayer's incentive to donate to charity or increase any other itemized deduction. Regardless of the increase in taxable income, any increase in itemized deductions is subject to tax savings according to the taxpayer's bracket.

  • Since the Pease provision is calculated based on gross annual income, it does penalize high-income taxpayers who feel the greater tax burden of more taxable income.
  • There is one exception to Pease that can reduce the incentive to claim additional deductions: If a couple's deductions are extremely small compared to their income, Pease uses an alternate formula in calculating the additional taxable amount, which reduces the incentive to claim more deductions.

However, most high-income taxpayers give to charity generously. Under the new law, the incentive for high-income earners to donate to charity will increase as the tax reward rises from 35 percent to 39.6 percent on each dollar.

Source: Alan Viard, "The Myth of the Limits on Itemized Deductions," The American, January 9, 2013.

 

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