As April 15 approaches, high-income taxpayers may be thinking about the impact of recent legislation limiting their itemized deductions. Under one part of the legislative package from January, itemized deductions are reduced once income exceeds a certain threshold: $250,000 for single taxpayers and $300,000 for married couples.
This is called a Pease reduction, after the original author of the provision. Charitable organizations are concerned that Pease will reduce the incentive for wealthy taxpayers to make charitable contributions. However, these concerns are based on a misunderstanding of how Pease affects itemized deductions.
To understand how Pease works, consider an affluent married couple — I will call them Joe and Judy. They have a combined taxable income (technically, “adjusted gross income”) of $500,000 and itemized deductions of $70,000. Under Pease, Joe and Judy’s itemized deductions are reduced by 3 cents for every dollar that their income exceeds $300,000. Their income is $200,000 more than the $300,000 threshold, so their itemized deductions are reduced by $6,000, from $70,000 to $64,000.
Now, suppose Joe and Judy gave an additional $1,000 to charity. If they did, their itemized deductions would rise from $70,000 to $71,000. Pease would still reduce these deductions by 3 cents for every dollar earned above $300,000, or $6,000, just as before. After the Pease haircut, Joe and Judy would have itemized deductions of $65,000 ($71,000 minus $6,000). So, as a result of their charitable contribution, their usable itemized deductions increase by $1,000, from $64,000 to $65,000. In other words, Joe and Judy effectively get the full deduction for the $1,000 charitable gift.
What’s going on here? The key point is that Pease reduces taxpayers’ itemized deductions based on their income, not on the amount of their deductions. Even if Joe and Judy had $200,000 in itemized deductions, the Pease haircut would only reduce their deductions by $6,000.
By contrast, suppose the joint income of Joe and Judy rose by $50,000 — from $500,000 to $550,000. Their income would now exceed the $300,000 threshold by $250,000, so Pease would reduce their itemized deductions by $7,500 (or 3 percent of $250,000), instead of the $6,000 before. In other words, the Pease haircut grows as the couple’s income increases.
Pease mainly functions as a stealth marginal tax rate increase on the wealthy, not as a mechanism for limiting deductions. Effectively, every dollar above the $300,000 threshold generates $1.03 in taxable income: one dollar from the income itself and 3 cents from the reduction in itemized deductions. For taxpayers in the top 39.6 percent bracket, Pease increases the effective marginal tax rate by roughly 1.2 percentage points — from 39.6 percent to 40.8 percent.
Of course, it’s possible for Pease to reduce itemized deductions by so much that the taxpayer decides to take the standard deduction instead of itemizing. If so, charitable organizations would have a very good reason to be concerned: Only itemizers can claim a charitable deduction.
However, this happens in rare situations, when itemized deductions are very low compared with the taxpayer’s income. For instance, a married couple, like Joe and Judy, with earnings of $500,000 would need to have itemized deductions less than $18,200 for this situation to arise. So long as they had more than $18,200 in itemized deductions, they would itemize even after the Pease haircut, meaning that Pease would not affect their incentive to claim a charitable deduction. In fact, Internal Revenue Service data show that itemizers with income between $250,000 and $500,000 claim, on average, more than $55,000 in itemized deductions.
So, in nearly all circumstances, charitable organizations need not fear the impact of Pease. Pease will raise the tax bill of affluent individuals based on the income that they earn, not the itemized deductions that they claim. Although high-income individuals may not like the cutback in their itemized deductions, Pease does not diminish the tax savings resulting from their charitable contributions.