Itemized deduction reform is a promising state budget solution

When Oklahomans filed their state income taxes in 2016, more than 70 percent of households used the standard deduction, which was $6,300 for individuals and $12,600 for married couples filing jointly. The remaining households itemized their deductions, adding up deductions for mortgage interest, charitable contributions, business expenses, and several other deductions allowed under federal and state tax laws.

Itemizing deductions is a strategy used almost entirely by wealthier households, since low- and medium-income households typically don’t spend enough on those categories to surpass the standard deduction. Overall, itemized deductions make our tax system more regressive by reducing tax bills for the wealthy but doing little for poor and middle class families who already pay the biggest share of their incomes in state and local taxes.

With Oklahoma lawmakers in search of solutions to fill a massive budget hole — especially solutions that won’t require a 3/4ths majority vote under SQ 640 — the time may be right to reform itemized deductions. Oklahoma is one of 17 states that follows the federal guidelines for itemized deductions, but 21 states with a state income tax either do not allow itemized deductions or limit them in ways that go beyond what’s allowed for federal taxes. Looking to these other states offers several models for itemized deduction reform to improve revenues for key state services:

Repealing itemized deductions

Currently 10 states do not allow any itemized deductions on state income taxes — Connecticut, Illinois, Indiana, Massachusetts, Michigan, New Jersey, Ohio, Pennsylvania, Rhode Island, and West Virginia. In these states, all households claim the same standard deduction. If Oklahoma were to join these states and repeal itemized deductions, we could increase state revenues by about $157.7 million, according to projections by the Institute on Taxation and Economic Policy. About 15 percent of Oklahoma households would see a tax increase from this change, but it would mostly affect the wealthiest households — 81 percent of the tax increase would be paid by the richest 20 percent of households with average incomes of more than $200,000.

Another option is to eliminate itemized deductions while simultaneously increasing the standard deduction available to all families. This would raise revenues while holding harmless or reducing taxes for low- and middle-income families. For example, repealing itemized deductions while increasing the standard deduction by one-fourth (to $7,938 for individuals and $15,975 for married couples in 2017) would cut taxes for 57 percent of Oklahoma households while increasing revenues by about $29.3 million. The middle 60 percent of taxpayers, with incomes between $20,000 and $89,000, would see an average tax cut of $48 from this change.

Capping itemized deductions

Itemized deductions do have valid purposes. For example, lawmakers may want to preserve deductions to maintain incentives for charitable giving or alleviate the burden of high medical expenses. We could do that for most families while paring them back for the extremely wealthy by capping the total value of itemized deductions.

Maine, North Carolina, and Vermont have all taken this approach in recent years. In Vermont, lawmakers capped itemized deductions at 2.5 times the standard deduction (in 2017, that means a cap of $15,875 for individuals and $31,750 for married couples). Adopting that approach in Oklahoma would increase state revenues by $72.2 million while increasing taxes on only 3 percent of households.

We could go even further and make tax calculations a bit simpler by capping deductions at $25,000 for individuals and $50,000 for married couples. That would increase state revenues by $50 million while raising taxes on only 1 percent of households. The households affected by this change would be primarily those with incomes in the hundred-thousands or millions. For these households, state taxes are a minor consideration compared to federal taxes and other spending goals. These very wealthy households would continue to receive the full federal deduction for charity, so a change affecting their already much lower state tax rate would not significantly reduce incentives for giving.

Limiting itemized deductions

A third approach could be to limit which itemized deductions can be claimed on state income taxes. Kansas and North Carolina have recently taken this approach by allowing only a few of the federal itemized deductions to be carried over to state taxes. Oklahoma has, too, with last year’s bill to eliminate the “double deduction” for state income taxes, so taxpayers can no longer deduct their state income taxes from their state income taxes.

We could go further to increase revenues while preserving some of the most popular itemized deductions. For example, Kansas eliminated all deductions except for charitable contributions and 50 percent of property taxes, mortgage interest, and mortgage insurance payments. If implemented in Oklahoma, this would boost state revenues by $75.2 million while increasing taxes on just 14 percent of households. This chart shows the revenue impact of these various options for reforming itemized deductions:

Of course, we wouldn’t need to exactly follow how Kansas or any other state reformed deductions. With any of these approaches, Oklahoma could tailor a plan to fit our state by deciding which deductions to eliminate or reduce. We have plenty of options for ways to broaden the tax base and boost revenues. In the current budget emergency, it’s time to use those options.