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In our newly updated policy brief on State Treatment of Itemized Deductions, we review a menu of options available to states interested in reforming these regressive income tax breaks. We also show that while several states have recently taken action on this issue, most states still have room to improve their itemized deduction policies. Every state has an upside down tax system that leans more heavily on low- and middle-income families than high-income residents. And many states have serious revenue needs created by underperforming economies or tax cuts passed in prior years. The itemized deduction reforms outlined in our brief can help address both the issues of tax fairness and revenue adequacy at the same time.
Itemized deductions are tax breaks intended to help defray a wide variety of personal expenditures that affect a taxpayer’s ability to pay taxes, including charitable contributions, extraordinary medical expenses, mortgage interest payments, and state and local taxes. But the breaks reduce state funding for public services by billions of dollars each year while primarily benefiting high-income households that generally don’t need such generous tax benefits. Most states with income taxes can therefore find something in the menu of itemized deduction reforms to add a healthy boost of progressivity to their revenue structures, cut unneeded fat from their tax codes, and/or generate new revenue for vital public services. Our brief catalogs 10 states that do not allow itemized deductions and 11 others (and DC) that have implemented reforms paring back itemized deductions for at least some taxpayers.
The most popular item currently on the menu is to build upon existing federal rules that phase down the value of itemized deductions for people with very high incomes ($311,300 and above for married couples in 2016). States can add their own flavor to these rules by beginning the phase-down at a somewhat lower income level, phasing down the deductions at a faster rate, and/or completely phasing them out once income reaches a certain point.
States with big appetites for reform can opt for even larger overhauls of itemized deductions, such as eliminating them entirely. Others may opt to selectively eliminate some deductions while retaining a few staple deductions like those for medical expenses or charitable contributions. Portion control can also be effective, in the form of a simple cap on the total amount each filer can deduct. Still other options remain, and ordering off the menu is encouraged as well.
Because low- and middle-income families benefit very little, if at all, from itemized deductions, most of these reform options have little effect on those groups. But they do pair well with measures like increasing the standard deduction available to all families, enhancing state Earned Income Tax Credits (EITC), or taking other more targeted measures to promote tax fairness beyond itemized deduction policy.
And itemized deduction reform is growing in popularity, as many states have taken this information to heart and taken steps to moderate their exposure to the more harmful aspects of these deductions. Rhode Island took a comprehensive approach in 2010, eliminating all itemized deductions while increasing the standard deduction that is available to taxpayers of all income levels, along with multiple other changes to its tax code. Another similar example is Maine, which in 2015 became the first state to fully phase out itemized deductions for the very wealthy. That same year, Vermont enacted a cap on total deductions set at 2.5 times the standard deduction. Just last week, Oklahoma eliminated its nonsensical state income tax deduction for state income taxes. And Louisiana Gov. Bel Edwards has asked lawmakers to consider itemized deduction reforms in the special session that convenes there next week.
All states considering such reforms should do so carefully and avoid the temptation to fall into other bad tax habits that could leave their tax codes even more unbalanced and starve them of needed revenue. North Carolina and Kansas, for example, enacted packages that included some positive itemized deduction reforms but proved destructive on net, leaving behind a revenue structure that was less progressive and less capable of bringing in revenue than the system that preceded it, necessitating major cuts to public services in those states. If not handled carefully, reform packages like these can be a bit like cutting Ho Hos out of your diet and replacing them with Twinkies — the net effect is a wash at best and might be much worse.
State policymakers looking to the menu of itemized deductions reforms we compile in our brief should resist the temptation to combine them with fiscal fad diets like flat income taxes and large unaffordable rate cuts. But if implemented with care, these options have promising potential to improve the balance, adequacy, and long-term health of their state tax structures.