Itemized deduction proposal has flaws, but opponents’ claims are overstated

With only a couple of week lefts in the Legislative session, lawmakers are scrambling to put together a budget that avoids devastating cuts to Oklahoma communities. The latest revenue idea to emerge is to limit itemized deductions to $17,000 per tax return, which would increase revenues by $107 million or $166 million, according to different estimates. This idea has been introduced as HB 2347 and approved by the House Joint Committee on Appropriations and Budget (JCAB), though it has recently been pulled from further consideration as lawmakers discuss revising it.

Itemized deduction reform is a promising state budget solution because it would not require the difficult-to-reach 3/4ths supermajority support for a tax rate increase under SQ 640. It also would not harm the large majority of low- and middle-income taxpayers who take the standard deduction instead of itemizing. Under HB 2347, even families and individuals who do itemize would not be affected unless they take more than $17,000 in deductions. A bill to freeze the standard deduction that would affect lower income taxpayers (HB 2348) has already been passed by the Legislature and sent to Governor Fallin, so HB 2347 would help ensure the cost of fixing Oklahoma’s budget shortfall is dispersed across both lower and higher-income households.

An estimate prepared for OK Policy by the Institute on Taxation and Economic Policy (ITEP) finds that capping itemized deductions at $17,000 would mean a tax increase for 7 percent of Oklahomans and bring in $107 million; 92 percent of the tax increase would be paid by the wealthiest fifth of households. The Oklahoma Tax Commission’s estimate says the change would affect 10 percent of households and bring in $166 million, but they similarly find that 63 percent of the increase would be paid by households making $200k or more, and just 1.7 percent of median income households would be affected.

A statement by former Senator Tom Coburn and the Oklahoma Council of Public Affairs tries to emphasize the total number of households that would see any effect from this change to dramatize the cost, but the reality is very few would see a change in taxes matching more than a very small portion of their income. Even the very wealthiest taxpayers most affected by this change would only see a 0.2 percent tax change as a percentage of income, according to ITEP.

Another vocal opponent of this idea has been the Oklahoma Center for Nonprofits, which argues that limiting the deduction for charitable giving would damage philanthropic support of nonprofits. However, their claims that this change would have a significant effect on philanthropy are overstated. Especially for the large donors with very high incomes, the tax break on state income taxes (with a top rate of 5 percent) is small compared to the break on federal taxes (with a top rate of 39.6 percent). The federal tax deductions would be unaffected by this change, so plenty of incentives for giving would remain, besides the fact that most donors give because they believe in supporting the work of a non-profit, not simply to gain a tax benefit.

Non-profits working with the most vulnerable Oklahomans also have a lot to lose if the budget deal doesn’t bring in enough revenues. When state services fall apart, non-profits simply don’t have the capacity to pick up the slack. And a large number of non-profit social service and health care providers depend on government contracts for their revenues — government is already the biggest single contributor to non-profits nationwide.

That’s not to say the current proposal to cap deductions is without flaws. One major concern is that because the $17,000 limit is the same for individual filers, heads of households, and married couples, it creates a significant marriage penalty where couples will be paying higher taxes than two individuals with the same incomes.

Lawmakers could respond to these concerns by amending the deductions cap in a variety of ways — such as removing the marriage penalty and fully or partially carving out charitable contributions from the overall cap. Lawmakers are looking at revising the bill to respond to these concerns. The trade-off for any of these changes will be less revenues to plug the budget hole and greater pressure to pursue all of the other revenue options on the table.

A much simpler alternative that wouldn’t create the same concerns for non-profits and married couples would be to restore a higher top income tax rate for very high incomes. For example, the Save Our State Budget Blueprint calls for a 6 percent rate on taxable income above $200,000 for individuals and $400,000 for those filing jointly, which would generate $94.8 million in revenue for FY-2018. We’ve previously called for a 6 percent rate on individual income above $100,000 and 7 percent on income above $200,000, which would bring in about $204 million. Or Oklahoma could reverse the most recent income tax cut and restore the 5.25 percent top rate to bring in $147 million.

Unfortunately, these simpler, more directed approaches are much harder for lawmakers to pass because of SQ 640’s supermajority requirements. It’s a clear example of how SQ 640 is systematically distorting our public policy, even when a majority of lawmakers and the public agree that we need to raise revenue.