Did you realize the state actually spends money to reduce taxes for some groups of taxpayers? Or, another way of thinking about it, the deductions and exemptions in our tax system mean the state is giving up potential tax revenue. Those deductions and exemptions – called tax expenditures – are an area of state spending that gets significantly less scrutiny than spending on public services.
A new report from the Institute on Taxation and Economic Policy (ITEP) focuses on reforming one type of tax expenditure: itemized deductions on the individual income tax. These allow taxpayers to deduct certain expenses (such as home mortgage interest or extraordinary medical expenses) from their incomes, thereby lowering the amount of their income subject to tax.
The idea of taking a closer look at these tax expenditures is not new one. In the 2009 Legislative Session, House Tax Committee Chair Ann Lenczewski proposed a widespread reform of tax expenditures, including eliminating a number of income tax deductions and credits, and replacing them with fewer credits that would have been accessible to more taxpayers. A modified version of this proposal passed in the House omnibus tax bill, but did not become law.
Itemized deductions are intended to take into account large or unusual expenses or encourage certain kinds of behavior. But, as ITEP notes, itemized deductions create an upside-down benefit, giving the most financial help to the best-off taxpayers. That is true for two reasons.
- Higher-income taxpayers are more likely to use itemized deductions. They tend to have larger mortgage interest payments and state tax bills, making it more advantageous to itemize, rather than take the standard deduction. Low- and moderate-income families typically take the standard deduction. In fact, in 2006, only 35 percent of federal tax filers itemized their deductions
- Higher-income households get a larger benefit from itemized deductions because they are in higher tax brackets. ITEP provides the following federal income tax example comparing two homeowners, each of which made $10,000 in mortgage interest payments. For a middle-income household in the 15 percent federal tax bracket, that deduction is worth $1,500 in reduced taxes. For an upper-income household in the 35 percent tax bracket, the deduction is worth $3,500 – that’s $2,000 more than the middle-income household gets for paying the same amount of mortgage interest.
ITEP offers several reform options on itemized deductions that would put taxpayers on a more equal playing field.
- Repeal state itemized deductions. Instead, all taxpayers would take the standard deduction, which would be increased by using some of revenue raised by repealing the itemized deductions.
- Cap the total value of itemized deductions.
- Convert itemized deductions to credits – so the amount of tax benefit is related to the size of the expense, rather than increasing with income.
- Phase out the value of itemized deductions for the best-off taxpayers.
- Adopt a policy that phases out tax deductions for higher-income taxpayers (based on a federal policy that was repealed in the early 2000s).
ITEP finds that adopting Option 1 (repealing itemized deductions and increasing the standard deduction) would raise the most revenue for Minnesota – an estimated $270 million a year. And more than half of taxpayers would still see a reduction in their taxes.
The environment at the state Capitol seems ripe for another serious look at tax expenditures. Other states have already acted to eliminate itemized deductions, cap their total value, or replace deductions with credits. As Wayne Cox, director of Minnesota Citizens for Tax Justice, points out in a recent media release, “the ITEP report identifies sensible strategies for providing a portion of the revenue needed to protect vital services while making the overall tax code fairer.” Now is a good time for Minnesota to take a closer look at our tax expenditures and consider reforms that will make the tax system fairer and raise revenues that will preserve vital services.