Tax deductions: the big kahuna

This is the third in a series of posts about the January 27 meeting of the House Ways and Means Committee, which explored the tax expenditures and deductions available under the state’s tax code. Part 1 concerned tax expenditures; part 2 focused on the tax deduction for medical expenses as an indicator of the widespread distress caused by our pre-Obamacare health system. 

It’s no secret that state lawmakers are looking for ways to raise some extra revenue without causing too much pain. One area under close examination is the tax code, and all the ways we allow people and businesses to limit their tax liability.

Some tweaks are possible in the tax expenditure side of things. But tax deductions actually offer a better opportunity to make our tax system fairer while giving the money tree a modest shake.

It’s an underreported fact that the wealthy actually get the best deal in our supposedly progressive tax system. According to the Institute on Taxation and Economic Policy, the wealthy pay the lowest per-capita share of state and local taxes combined, and they pay the lowest actual income-tax rate of any group besides the poor. Top earners are subject to an income tax rate of 8.95%, but the amount they actually pay is only 5.1%.

The single biggest reason for that disparity? Our generous rules on taxable income and tax deductions. A couple of examples from the category of Bet You Didn’t Know… (all information from the Joint Fiscal Office; tax figures are from the 2011 tax year)

— “Interest You Paid” is tax deductible. For most of us, that means mortgage interest. But it also applies to vacation homes — and boats. That chiefly benefits the wealthy. Renters, who tend to be at the bottom of the income scale, don’t benefit from the mortgage deduction.

— Property taxes are deductible. Including property taxes paid in other states. Again, that benefits those sufficiently well-off to own multiple properties.

— Charitable contributions can be deducted up to 50% of a taxpayer’s adjusted gross income. Only the wealthy can support anywhere near that level of giving. And, given the proliferation of ersatz foundations, it’s easy for a person of means to effectively launder money through a nonprofit. (For example, check out the nonprofit empire spawned by the Koch brothers.)

The power of this virtually unlimited allowance? Among Vermont taxpayers with incomes over $1 million, the average charitable deduction — the average — was $131,360. That’s a lotta stops at the Sally Army bell-ringer.

But here’s the biggest eye-popper of them all. If you add up all the average deductions for Vermont’s million-dollar class, you get $528,000.

That’s right: the average million-dollar taxpayer claimed deductions worth more than half their income.

And that’s how 8.95% turns into 5.1%.

The numbers for those earning less than $1 million are not quite so appalling, but the upper and upper middle classes clearly benefit from our current tax code. The primary reason: our permissive rules on tax deductions and taxable income.

Setting limits

The 2011 standard deduction in Vermont was $5,800 for a single taxpayer, $8,500 for a head of household, and $11,600 for a married couple filing jointly. Peanuts by comparison. I bring this up because Betcha Didn’t Know that 10 of the 50 states don’t allow itemized deductions. Everyone gets the standard — no more, no less.

That option could be on the table. It would bring the effective tax rate for top earners much closer to statutory levels. The resulting revenue could be used to cut taxes on the middle class, who get hit hardest by Vermont’s tax system; or they could be used to close the budget gap without sacrificing state services.

I’m not expecting anything that radical from our frequently timorous Legislature. But as recently as two years ago, the House passed a bill that would have capped itemized deductions at 2.5 times the standard. That bill died in the Senate, mainly because of Governor Shumlin’s opposition.

Yes, our Democratic Governor blocked the path to a fairer tax code. Wait, let me double-check… Yep, he’s a Democrat. Says so, anyway.

If that bill had passed, members of the Million-Dollar Club would have seen their deductions capped at $29,000 — a far cry from $528,000.

The situation may be different this year, as the state faces a large budget gap and Shumlin has deliberately soft-pedaled his anti-tax stance. During his budget address, he stated his opposition to “raising income, sales, and rooms & meals tax rates” — very deliberately emphasizing the word “rates,” which had not been part of his boilerplate in the past.

If that wasn’t signal enough, Shumlin’s budget proposed an end to the tax deduction for state income taxes paid in the previous year. And with that, as Ways and Means chair Janet Ancel told me, “He put the whole discussion about itemized deductions on the table.”

Ancel would not commit to revisiting the deduction-capping bill, but it’s clearly on her mind. “It [would have] made the tax system more fair,” she says. She may get a second bite at the apple this year, and thanks to our budget situation it might actually pass muster with the Governor. One can only hope.

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4 thoughts on “Tax deductions: the big kahuna

  1. Sophia du Brul

    Here is my thought on the mortgage deduction. Limit the deduction to primary residence and $500,000, meaning that everyone can deduct the mortgage interest on any loan amount up to $500,000. If the mortgage is 1 million, then that taxpayer can deduct half the interest. This way, the majority of middle class tax payers with a single home can still deduct all of their mortgage interest, but it closes the loophole for the super rich. The average mortgage is $235,000 in the US.

    Reply
  2. Cynthia Browning

    Below is the short version of my proposal to reform both the income tax and the property tax. If anyone wants the longer two page version, or the still longer 3 page version, just let me know at cbrowning@leg.state.vt.us . I presented this to House Education this morning, but don’t expect that they will pursue it. Cynthia B.

    INTERACTIVE TAX REFORM: Proposals to Address Imbalance, Inefficiency, & Inequity in the Property Tax & the Income Tax.
    For House Education Committee 2/4/15
    Rep. Cynthia Browning, Arlington
    cbrowning@leg.state.vt.us 802.375.9019 (H) House Seat 67, Room 33

    ( 1 ) Remove the costs of the Income Sensitivity Program (about $140 m) & the Current Use Program (about $40 m) from the Education Fund & finance them in the General Fund or connected to the income tax.
    *** This lowers net costs in the EF by about $180 m
    *** Therefore we can lower base property tax rates by about 18 cents
    *** The costs of these two programs will be decreased by almost one fifth
    since the property tax rates that determine the cost of the subsidies
    needed are so much lower.

    ( 2 ) Limit the rate of increase in Education Spending overall and for each district for several years, either with alterations in the base education amount and the excess spending penalty threshold or by an actual mandated cap on the rate of increase. The decrease in property tax rates is not to be treated as an opportunity to increase Ed spending.

    ( 3 ) Change the application of the Vermont state income tax rates from Taxable Income to Adjusted Gross Income as recommended by the Blue Ribbon Tax Structure Commission.
    *** This will eliminate about $330 m in tax credits, deductions, and exemptions. About $200 m in the extra revenue should be used to reduce all income tax rates by one to three percentage points as possible, in a progressive way.
    *** About $100 m of the extra revenue should be used to finance the Income Sensitivity and Current Use programs in the General Fund, along with existing general fund line items connected to these programs.

    RESULTS:

    *** INCREASE IN EFFICIENCY: The Current Use and the Income Sensitivity programs cost less since the vicious cycle in which rising property tax rates cause increases in the costs of these programs, which then contributes to rising property tax rates is broken.
    *** INCREASE IN EQUITY: Violations of the principles of horizontal and vertical equity in the income tax system are lessened by reducing the opportunities to reduce tax obligations using special provisions.
    *** INCREASE IN ACCOUNTABILITY: The state has now taken responsibility for paying for policy priorities that are NOT education in the General Fund rather than on the state education property tax. This in effect shifts some of the existing cost of education onto the income tax, so that creating a compound education tax payment between property and income may no longer be needed. In return for this responsible behavior, the School Districts will be required to control the growth in their spending.
    *** LOWER TAX RATES: Income tax rates and property tax rates are both much lower. How particular taxpayers might fair is something that needs to be analyzed, but the intent is that the only people who might end up paying more would be those who reduced their tax obligations substantially using the special tax provisions that would be eliminated.

    Reply
  3. chuck gregory

    Voters must not understand this stuff, John. If they did, they’d do something about it. Why bother reporting it?

    Reply

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