Limiting itemized deductions would improve the fairness and adequacy of the state income tax

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.

ABOUT THE AUTHOR

David Blatt helped found OK Policy in 2008 and became the organization's Executive Director in 2010. David previously served as Director of Public Policy for Community Action Project of Tulsa County and as a budget analyst for the Oklahoma State Senate. He has a Ph.D. in political science from Cornell University and a B.A. from the University of Alberta. David has been selected as Political Scientist of the Year by the Oklahoma Political Science Association, Local Social Justice Champion by the Dan Allen Center for Social Justice, and Public Citizen of the Year by the National Association of Social Workers. He lives in Tulsa with his wife, Patty Hipsher, a special education teacher in Broken Arrow, and their son, Noah.

4 thoughts on “Limiting itemized deductions would improve the fairness and adequacy of the state income tax

  1. “double deduction” – are you kidding me?? Your blog and position are misleading.

    We don’t get to deduct SIT twice. We just get to claim our Federal I/D’s on form 511. If you want to eliminate that deduction as a way to increase tax revenue without raising tax rates (politically insane), then so be it. But don’t allude to the public that “wealthy” taxpayers are getting a double deduction. We are getting the deduction provided to us by the OK statutes.

    Your weath-shifting position at the state level ignores the same realities that are ignored at the federal level – higher earning taxpayers pay more tax, regardless of their deductions. The OK Form 511 starts with Federal AGI and then you get to take you I/D’s or the State’s Standard Deduction – same as the Federal tax system.

    Yes, $15,000 in mortgage interest deduction is worth more to someone in the higher tax bracket than it does to someone in the lower tax bracket – but that’s just it – they are in the higher tax bracket. The fact that lower to middle income taxpayers don’t get to take advantage of the I/D is not relevant because they also pay less tax to begin with.

    Are you going to put everyone in the same tax bracket if you eliminate the I/D deduction? I don’t think so. You just want to transfer wealth. The one statistic you left out in the blog was the key statistic – How much of the tax revenue collected by the STOK today is paid by the low to middle income taxpayer versus the taxes collected from everyone else?

    By they way – do you take the Federal I/D deduction on your OK Form 511? You don’t have to take that deduction. You can voluntarily claim the Oklahoma standard deduction. I assume you don’t take the higher deduction because you are morally outraged by the fact that “weathly taxpayers” get a double deduction.

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