The Institute on Taxation and Economic Policy (ITEP) has released a new study on itemized deductions for income taxes. These deductions have a negative effect on tax fairness, with most of the benefit accruing to high-income taxpayers. Most states follow in the footsteps of the federal government in their approaches towards itemized deductions, but the good news is that Wisconsin is in the minority of states that take a variety of approaches to limit the regressive nature of the deductions.
Itemized deductions represent a group of several separate personal income tax deductions available on federal tax forms and most states. Widely-used deductions include those for mortgage interest and charitable contributions. Taxpayers generally have a choice between using a standard deduction or itemizing their deductions, and using whichever is higher. This income is then shielded from income taxes.
Higher-income taxpayers disproportionately benefit from itemized deductions in part because their income is taxed at a higher rate. The ITEP report compares a hypothetical middle-income family paying at the 15% federal tax rate and a higher-income family paying at the 35% rate. If both have $10,000 in mortgage interest and itemize their deductions, the middle-income family will receive a benefit of $1,500 while the wealthier family will benefit by $3,500. Higher-income families also benefit more because they are more likely to have enough special deductions to exceed the level of the standard deduction.
The ITEP report finds that most states follow in the federal footsteps in their approach to itemized deductions, thereby ensuring the regressive nature of the deductions is replicated at the state level. Wisconsin, however, is one of a few states that has chosen to make itemized deductions less regressive by converting them to a credit of 5% of the amount in excess of the standard deduction.
According to the Wisconsin Department of Revenue, about 756,000 tax filers used the itemized deduction credit in tax year 2008, out of about 2.9 million tax filers (26%). The total credits used total $344 million, with an average benefit of $455.
Wisconsin’s approach using tax credits, although less regressive than the itemized deductions, still predominantly benefits upper-income filers: In 2008, 57% of the credits used benefit filers at least $100,000 in income. This is because expenses that qualify for the credit tend to be higher for filers with larger incomes, and because expenses are eligible for the credit only to the extent that they exceed the standard deduction, which is higher for lower-income filers and phases out completely at high levels of income.