A word or two about the "Pease" limitation

As part of its campaign to lobby Congress "to preserve the charitable tax deduction in its current form," the Alliance for Charitable Reform has urged that the deduction be excluded from the overall limitation on itemized deductions, which ACR calls a "hidden tax" that "covertly chips away at the charitable deduction."

The words "hidden" and "covertly" have to do with something called "tax salience," which we will return to a bit later.

I have issues with the campaign more generally, but on this particular point the ACR is simply wrong. The "Pease" limitation has little or no effect at all on the charitable deduction.

What it is

For purposes of the present discussion, we will assume the marginal rate at which the charitable deduction reduces an individual's income tax actually provides a significant incentive. The literature on this question is mixed at best, but let's just take it as a given.

Section 68 of the Internal Revenue Code, the so-called "Pease" limitation, reduces the amount a higher income taxpayer may claim in itemized deductions. The limitation was first enacted in 1990 as a temporary measure, with the stated purpose of increasing the progressivity of the income tax. The income threshold was $100k. The limitation was made permanent in 1993 and indexed for inflation.

The first of the Bush tax cuts, enacted in 2001, included a mechanism phasing the limitation out over four years, from 2005 through 2009. The limitation was reinstated as part of the thirteenth hour "fiscal cliff" compromise legislation enacted in January, 2013, but with considerably higher income thresholds.

So there was a three year interval during which the limitation did not apply.

How it works

The "Pease" limitation reduces a taxpayer's itemized deductions by the lesser of three pct. of the amount by which her income exceeds a stated threshold, or eighty pct. of itemized deductions otherwise allowable.

Eighty percent sounds scary. But how does the math actually work.

To start with, what are the thresholds. For 2013, the limitation kicks in at $250k for a single taxpayer, $275k for a head of household, $300k for joint filers, and $150k for married taxpayers filing separately. These figures are adjusted annually for inflation, and will be marginally higher in 2014.

My purpose here is to illustrate some basic principles, so rather than do the math eight or ten times, let's just look at joint filers, using the 2013 thresholds. Single taxpayers tend to skew young, and fewer than one pct. have taxable income above the "Pease" threshold. Something to keep in mind.

A married taxpayer filing jointly with taxable income of $300k in 2013 is in the middle of the 33 pct. marginal rate bracket. The bracket floor for the 35 pct. bracket is $398.35k, and the bracket floor for the 39.6 pct. bracket is 450k. These figures are also adjusted annually for inflation.

In 2011, the last year for which data is available, fewer than 7.5 pct. of joint filers reported adjusted gross income above the $300k threshold. Nearly all of these filers itemized, and nearly all itemizers claimed at least some amount as a charitable deduction.

Total amounts claimed for charitable contributions in 2011 aggregated about one-fifth of all deductions claimed, and were roughly equivalent to amounts claimed for home mortgage interest and for taxes paid.

Data from 2010 focusing specifically on higher income taxpayers breaks this down a little further, showing that for more than half of taxpayers with adjusted gross incomes of $200k or more, the deduction with the largest tax effect was for taxes paid, and among that group the second most significant deduction was for mortgage interest paid, with the charitable deduction a distant third.

The charitable deduction was the most significant deduction on only about eight pct. of returns in 2010, and among that group the second most significant deduction was for taxes paid, with mortgage interest a distant third.

The point being, we need to keep in mind that higher income taxpayers claiming charitable deductions will generally also be claiming deductions for home mortgage interest and/or state and local income taxes and/or property taxes. Often these will moot the question whether the "Pease" limitation has any effect on the rate at which charitable contributions are deductible.

The math itself

So again, to keep the math simple, let's suppose a couple with adjusted gross income of half a million, some distance into the top marginal rate bracket and $200k above the "Pease" threshold, meaning itemized deductions might be reduced by as much as $6k. At a marginal rate of 39.6 pct., this would result in an additional $2,376 in income tax.

The eighty pct. limitation would kick in only if claimed deductions were less than $6k. Again, if the couple have any substantial mortgage interest or state or local income and/or property taxes, the "Pease" limitation will have zero effect on the deductibility of their charitable contributions.

Or to take it up a notch, let's suppose a couple with adjusted gross income of $2.3 million -- well into the 39.6% rate bracket, and $2 million above the "Pease" threshold, meaning itemized deductions might be reduced by as much as $60k, resulting in additional tax at 39.6 pct. of $23,760.

Here, the eighty pct. limitation would kick in if claimed deductions were less than $60k, which sounds a bit more likely. But let's note a few things.

First, when we are talking about joint filers with adjusted gross income over $2 million, we are talking about just over one-sixth of one percent of all joint filers. Among itemizers, who comprise not quite half of all joint filers, we are talking about less than a third of one percent. Fewer than a hundred thousand couples, nationwide.

In the $2 to $5 million income range, contributions averaged a little under $100k per return in 2011. These figures are not broken out by filing status, so we can suppose the number is a bit higher among joint filers. Home mortgage interest averaged a little under $28.5k per return, and taxes paid averaged almost $224k, of which the lion's share was state income tax.

But okay, let's suppose a couple who own their house outright, or rent, in a state that has no income tax. Every nickel by which their itemized deductions are reduced is coming out of their charitable contributions.

What effect does (or should) this have on their inclination to give? Again, setting aside the literature that says income tax incentives for charitable giving are not all that strong anyway.  And setting aside the fact that higher income taxpayers tend to give to private colleges, art museums, and donor advised funds, rather than to soup kitchens and homeless shelters.

An economic analysis

I am about to get all counter-intuitive on you, so bear with me. And actually, this reasoning was set out very clearly in a report by the staff of the Joint Committee on Taxation in 2001 in preparation for a Senate Finance Committee hearing on the proposal to phase out the "Pease" limitation.

This is the takeaway: the amount by which the "Pease" limitation reduces the tax benefit of an itemized deduction is determined not by the amount of the deduction itself, but by the amount by which income exceeds the threshold.

In other words.

If our couple is in the 39.6 pct. marginal rate bracket, and they are itemizing deductions, each additional dollar of income is taxed as though it were a dollar and three cents, bringing their marginal tax rate to 40.79 pct. Or maybe less, if the total of itemized deductions does not bring them to the eighty pct. limitation. Each dollar they contribute to charity still generates a deduction of 39.6 cents, the nominal marginal tax rate.

In a way, this is somewhat akin to the proposal that has appeared in each of the Obama administration's budgets, to cap the rate at which itemized deductions reduce taxable income at 28 pct., though there are now three brackets above that rate. And of course, ACR has been vocal in opposing this proposal as well.

What is "hidden" here is not an impairment of the tax benefit of the charitable deduction, but rather an increase in the marginal tax rate for high income itemizers, who supposedly can afford it. Progressivity, in other words. Nothing is "covertly chipping away" at the deduction itself, which remains intact.

A closing thought on "salience"

"Tax salience" has to do with whether a mechanism of the tax code is sufficiently visible to function effectively as an incentive or disincentive a taxpayer's behavior.

While the "Pease" limitation is not intended to discourage taxpayer spending on deductible items, and an economic analysis shows it should not, it seems to have a perverse "salience" that somehow allows ACR to mount an ostensibly credible campaign to exclude the charitable deduction from its reach.

As with so many public policy matters, the discussion is easily dominated by demagoguery.