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.
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