Earlier this year, we called attention to one of the stranger loopholes in the Oklahoma tax code, the case of the “double deduction” of state income taxes. Federal tax law allows taxpayers who itemize their deductions to claim a deduction for state income tax, along with such expenses as home mortgage interest payments, charitable contributions, local property taxes and extraordinary medical expenses. While Oklahoma is among 31 states that allow taxpayers to itemize their deductions on their state income tax return as well, only in Oklahoma and five other states are taxpayers allowed to claim a deduction for state income taxes on their state tax return. In the context of the state’s huge revenue shortfalls and painful budget cuts, we urged the Legislature to follow New Mexico’s lead in taking action to disallow this deduction, which, according to estimates provided us by the Institute on Taxation and Economic Policy (ITEP), would generate $118 million in additional revenue. Since only a minority of mostly wealthier taxpayers itemize their deduction, eliminating the deduction for state income taxes would also help address the inequities of our tax system, where low- and middle-income Oklahomans pay more of their income in state and local taxes than do the wealthy. This proposal generated some interest but did not make its way into the final FY ’11 budget agreement.
ITEP is now out with a new report that provides a critical look at the subject of itemized deductions more broadly. Their basic argument is that itemized deductions are an extremely regressive component of tax systems:
Itemized deductions impact tax fairness: low-income families receive virtually no benefit from these deductions, and the biggest benefits are reserved for the upper-income families who arguably need them the least
In Oklahoma, according to IRS statistics (Excel file), almost three out of every four taxpayers had household income under $50,000 in 2007, yet only one in eight of these low- and moderate-income households claimed itemized deductions. By contrast, seven out of every eight households with income over $100,000 itemized their deductions, and this population – just 8 percent of all Oklahoma households – accounted for a full 47 percent of the $10.6 billion in total itemized deductions claimed in 2007. Adding to the regressivity of the itemized deduction is the fact that the same deduction – say $15,000 in mortgage interest payments – is worth more to someone in the top income tax bracket than to someone in a lower tax bracket.
There are various policy options that states that currently allow itemized deductions could consider to make them less costly and less regressive. ITEP sets out five of these and calculates the impact these options would have for state revenue collections and for various categories of the population. The three main proposals are:
- Option 1 – Repeal itemized deductions entirely while ensuring that most middle- and low-income families are held harmless by simultaneously increasing the standard deduction available to all families. Rhode Island recently adopted this bold approach, joining nine other states that have an income tax but do not allow any itemized deductions. If Oklahoma were to eliminate itemized deductions and increase the standard deduction so as to protect low- and middle-income households , it would generate $104.4 million in additional revenues. More than twice as many households would see a tax cut (48 percent) as a tax increase (21 percent) under this proposal;
- Option 2– Cap the total value of itemized deductions. If a cap were set at $40,000 for married couples and $20,000 for singles, it would generate $106.2 million in additional state revenue, while affecting just 4 percent of Oklahoma taxpayers.
- Option 3 – Convert itemized deductions to credits. This approach, which is in effect in Wisconsin and Utah, would address the situation where the same deductions are more valuable to taxpayers in higher tax brackets than in lower tax brackets. Under the scenario developed by ITEP, which sets the credit at 4 percent of total deductions, increases the standard deduction, and phases out eligibility, Oklahoma could generate $112 million while providing a tax cut for most lower- and middle-income families.
ITEP also considers two options that involve phasing-out itemized deductions for the highest-income taxpayers that would have a more modest revenue impact.
One important component of all these options is that a significant portion of the cost to taxpayers would be offset by reduced federal tax liability, since taxpayers can deduct their state income tax from their federal taxes. As ITEP explains it:
This “federal offset” means that state income tax hikes on upper-income families are always substantially less burdensome than they may appear at first glance.
Anywhere from roughly 20 to 30 percent of the additional Oklahoma states taxes paid under ITEP’s proposals would be offset by reduced federal tax payments.
The additional tax revenue from eliminating or limiting itemized deductions could be used to bring the state’s budget back into balance and restore funding to vital services. Alternately, the revenue could be used at least in part to pay for tax cuts that would benefit a much broader segment of the state’s population – for example, by increasing the standard deduction or personal exemption, stretching out our tax brackets, or further lowering top rates. Whichever approach is taken, curbing these itemized deductions that primarily benefit those at the upper end of the income spectrum would constitute important steps towards the goal of creating a fairer tax system for Oklahomans.