Charging Through the Back Door

Provision in cliff bill raises effective tax rate, could hurt charities

President Barack Obama and Vice President Joe Biden make a statement regarding the passage of the fiscal cliff bill / AP
January 7, 2013

A change in how itemized deductions are calculated is raising worries among economists and nonprofits that the government may have unlocked a back-door revenue raiser that could hurt charitable giving.

The so called "Pease limitation" on itemized deductions, named after the congressman who created it, came back into effect in the fiscal cliff bill that passed early this year. It existed during the Clinton years before the 2001 Bush tax cuts temporarily rolled it back.

"It’s really just a stealth increase in tax rates," said Alan Viard, a former senior economist at the Federal Reserve Bank in Dallas and a tax expert at the American Enterprise Institute.

The Pease provision limits itemized deductions for taxpayers over a certain threshold. For each dollar that an individual makes over $250,000 or a couple makes over $300,000, their deductions are reduced by three cents.

So, for example, if an individual makes $350,000, which is $100,000 over the threshold for individuals, that person’s deductions are reduced by $3,000. However, the government is not allowed to take away more than 80 percent of a taxpayer’s deductions.

Alison Hawkins, director of external affairs at the Philanthropy Roundtable, expressed concern that the limitation could hurt charitable giving. The higher tax rates in the top income bracket will leave individuals with less money, she said, and the Pease provision will provide a smaller incentive to donate money by reducing the value of deductions.

Philanthropy Roundtable was concerned enough about the Pease limitation that it sent out an email explaining the change to donors and other supporters.

Some economists dispute that the incentive to give would actually decrease. However, they agree that the limitation does not increase incentives for charitable giving.

Deductions are worth more at higher tax rates, said Nick Kasprak, an analyst at the Tax Foundation.

The Pease limitation "operates effectively like another little increase in tax rates," said Eugene Steuerle, a tax expert at the Urban Institute.

The limitation multiplies the effective tax rate by 1.03 if taxpayers are over the threshold, he said. That puts the top marginal tax rate not at 39.6, its official rate, but at 40.8 percent, said Viard.

Because the rate increase is indirect it does not actually create any incentive to give, Steuerle said.

If "Congress increases taxes indirectly by phase outs rather than directly by rate increases, then there is no accompanying increase in charitable incentives," Steuerle wrote in an email to the Washington Free Beacon.

"We’ll have to see exactly what the effect is, but it’s not a positive effect," Evan Liddiard, a former Senate Finance Committee staffer, said in an interview with Alison Hawkins on the Philanthropy Roundtable’s website.

"Pease is small enough by itself that it doesn’t make a lot of difference," Steuerle wrote in an email. "And because of the way it operates, it really doesn’t reduce charitable incentives except in the narrowest of cases. But it doesn’t increase incentives as much as would have happened if Congress had not tried to hide the tax rate increase in this more complicated tax structure.

"It would be a lot simpler if you just had a 40.8 tax rate," Viard said.

Hawkins raised another concern: Congress could see this deduction limitation as an easy way to raise money without raising tax rates directly.

The limitation "showed up in this tax bill without a whole lot of fanfare," Hawkins said, arguing that Congress could easily tweak it to generate even more revenue.

"It’s an excellent way to raise taxes on somebody without making it seem like it’s a tax increase. It’s very much a back door tax increase," said Liddiard at the end of his interview with Hawkins.

The limitation raises hundreds of billions of dollars. Curtis Dubay, senior policy analyst at the Heritage Foundation, noted that the Committee for a Responsible Federal Budget estimated the government’s gain from the limitation to be $150 billion.

"There are lots of ways they could change it to raise more revenue," Dubay said. They could lower the threshold to catch more people with the limitation or raise the rate at which deductions are reduced, he said.

This is not the first time that the federal government has used backdoor means to generate revenue. Congress in 2011 raised rates at Fannie Mae and Freddie Mac for 10 years to raise enough revenue to cover a two-month extension of the payroll tax cut.

Kasprak said the goal of the limitation is to keep the wealthy from taking advantage of the tax code to reduce their effective tax rate, but he noted that there are several other parts of the code that do the same thing, creating duplication. The Alternative Minimum Tax accomplishes the same goal, he said.

The limitation has also added a layer of complexity that is confusing people and could inadvertently cause charitable donations to drop. Ari Fleischer wrote an editorial in the Wall Street Journal on Friday arguing that the limitation will decrease charitable donations.

Both Viard and Steuerle disputed the math underlying Fleischer’s claim, however.

"If taxpayers understand the Pease provision, it should not affect their incentive to give," Viard said.

"The question, I suppose, is whether people understand that," Viard said.

He said the confusion about it could cause people to reduce charitable giving out of a bad understanding of the limit.

"It may well be people will respond that way because they don’t understand how it works," he said.

"It’s a perfectly avoidable complexity," Viard said. "There’s no reason for it to exist."