In the recent tax legislation to avoid the fiscal cliff, Congress reinstated a limitation on itemized deductions for affluent taxpayers, known as Pease (after its original author, the late Rep. Donald Pease). Under Pease, itemized deductions are modestly reduced depending on how much a taxpayer’s adjusted gross income exceeds a specified threshold — $250,000 for an individual and $300,000 for a married couple.
Many commentators have voiced concerns that Pease will discourage wealthy taxpayers from making charitable donations. However, these concerns are misguided. Even under Pease, virtually all affluent taxpayers will be able to get the full deduction for any additional gifts to charity.
Here’s how Pease works for a typical affluent married couple (let’s call them Andy and Amanda), who have a combined income of $400,000 and itemized deductions of $50,000. Under Pease, a taxpayer’s itemized deductions would be reduced by 3 cents for every dollar of income that exceeds the threshold ($300,000 for a married couple). Since Andy and Amanda’s income is $100,000 above that threshold, their itemized reductions would be reduced by $3,000, from $50,000 to $47,000.
Yet, Pease does not undermine the incentive for affluent taxpayers to increase their itemized deductions. To see why, suppose Andy and Amanda gave an additional $1,000 to charity. Here’s what would happen. Their itemized deductions would rise from $50,000 to $51,000. Pease would then reduce these deductions by 3% of their income above $300,000, or $3,000 — no change there. So, after the Pease haircut, their itemized deductions would be $48,000 ($51,000 minus $3,000) — which is $1,000 higher than it was before they made the additional $1,000 contribution. In other words, this additional contribution is completely deductible.
This benign result occurs because Pease cuts back on the couple’s deductions based on the level of their income, not on the amount of their itemized deductions. As long as Andy and Amanda have joint income of $400,000, they will lose $3,000 in itemized deductions — regardless of whether their itemized deductions are $50,000 or much more.
By contrast, suppose the joint income of Andy and Amanda rose by $50,000 — from $400,000 to $450,000. Since their income rose, their Pease haircut would increase from $3,000 to $4,500 (which equals 3 percent of $150,000 — the amount by which $450,000 exceeds $300,000). Again, this $4,500 reduction occurs whether their itemized deductions are $50,000 or much higher.
Thus, Pease does not actually “limit” itemized deductions in any meaningful way. Instead, it functions as a stealth increase in the marginal tax rate for affluent people like Andy and Amanda. For every dollar of income earned above the $300,000 threshold, their taxable income increases by $1.03 — one dollar from that income itself, and three cents from the reduction in itemized deductions. For taxpayers in the top 39.6 percent bracket, this represents a roughly 1.2 percentage point increase in their effective marginal tax rate to a total of 40.8 percent.
In theory, Pease could eliminate enough itemized deductions to induce affluent taxpayers to take the standard deduction instead of itemizing their deductions. In this situation, a charitable organization should be concerned about disincentives for affluent taxpayers to make charitable donations, since only itemizers can claim a charitable deduction. However, for these disincentives to influence behavior in practice, taxpayers must have extremely low levels of itemized deductions relative to their income.
For instance, if a married couple making $1,300,000 per year had at least $42,200 in itemized deductions, they would still find it worthwhile to itemize even after the Pease haircut. By comparison, taxpayers with income between $1 and $1.5 million on average claim more than $160,000 in itemized deductions, according to IRS data. Thus, there would only be a handful of millionaires with so few deductions that Pease would have a meaningful impact on their charitable donations.
Moreover, Congress provided that Pease in no event may reduce itemized deductions by more than 80 percent. Of the 2 million taxpayers subject to Pease, only 44,000 would be affected by this 80 percent cap.
In short, despite the passage of Pease, the attraction of itemized deductions has not fallen for virtually anyone. Any increase in charitable deductions will almost always be fully deductible under Pease. Ironically, because the fiscal cliff legislation raised the top statutory income tax rate from 35 percent to 39.6 percent, the new legislation might actually enhance the attraction of charitable deductions to affluent taxpayers.
Robert C. Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. His latest book is “Extreme Productivity: Increase Your Output, Reduce Your Hours.’’