The Hidden Entitlements
PART III
Personal Tax Expenditures
1. Itemized deductions
Itemized deductions are the usual targets of various so-called "flat tax" proposals (which otherwise typically aim to expand loopholes, particularly for corporations and investment income).But while 
some itemized deductions lack a strong tax policy basis and can be criticized as inefficient or unfair subsidies, others can be seriously defended on tax policy grounds.
Mortgage interest on owner-occupied homes. Homeowners who itemize deductions can deduct mortgage interest on their primary and secondary residences.The regular mortgage interest deduction is limited to interest on debt no greater than the homeowner's basis in the residence, and the loan is also limited to no more than $1 million (for debt incurred after Oct. 13, 1987).Interest on home-equity loans on debt of up to $100,000 is also deductible,irrespective of the purpose of borrowing (provided that the debt does not exceed the fair market value of the residence).
The regular mortgage interest deduction is beloved by the real estate industry as a major federal subsidy for home purchases. The home-equity interest deduction is an exception to the general denial of deductions for personal interest that has no apparent rationale at all. Like all subsidies
structured as personal tax deductions, these interest write-offs lead to "upside-down" effects: the higher a person's income (and tax-bracket), the larger the share of mortgage interest that the government subsidizes. - If a family making $45,000 borrows $75,000 to buy a home, the federal government will offset about 13% of its total mortgage payments, a subsidy worth about $81 per month. But if a family making $500,000 takes out a $360,000 mortgage to buy a house, the government will subsidize about 35% of its mortgage payments, worth $1,020 a month.22
- In 1996, about 27 million tax returns are expected to show a deduction for mortgage interest. That compares to about 64 million home-owning families.Thus, more than half of all homeowners get no tax reduction at all from the mortgage interest deduction. Another 50 million or so families rent rather than own, and of course they get no help from the mortgage interest subsidy either. On average, mortgage interest deductions are worth almost$5,000 a year each to taxpayers making more than $200,000, but only $333 a year to families earning between $30,000 and $75,000.23
It seems obvious that a $43 billion a year direct government housing subsidy program with such bizarre effects would have no chance at all of being enacted.Nevertheless, the mortgage deduction has been on the books so long and is relied on by so many people that curtailing it would have to be done slowly and gradually to avoid serious unfairness during the transition. Some reformers have suggested eliminating the home equity loan loophole and the deduction for second homes and also lowering the cap on regular mortgage loans eligible for the deduction from the current $1 million. These are all excellent ideas,although lowering the cap on regular mortgages too much too quickly could create significant regional disparities (due to the wide range of housing costs).
State and local taxes. Itemizers can deduct the personal income and property taxes they pay to their state and local governments. (Sales taxes used to be deductible, but no longer are, in part 
because it was very difficult for people to keep track of what they actually paid in sales taxes and the alternative sales-tax-deduction tables provided by the IRS weren't very accurate.) The rationale for the tax deduction for state and local taxes is that people shouldn't be taxed on income that doesn't directly benefit them personally, but that they are required to pay in taxes to serve the general good. Put another way, a New Yorker making $50,000 is thought to have a lower ability to pay federal taxes than a Texan with the same gross income, because the New Yorker's state and local taxes are higher.
Some analysts argue, however, that deductions for state and local taxes are a subsidy for state and local services received by individuals. For example, they point out, communities with high property taxes may provide better schools and other services (e.g., trash collection, parks, etc.)than communities with low property taxes. There's no doubt that there is a strong correlation between the level of state and local taxes and the quantity and quality of public services. On the other hand, the state and local services that a particular person receives may or may not reflect the amount of state and local taxes that he or she pays.
Charitable contributions. Contributions to charitable, religious,and certain other nonprofit organizations are allowed as itemized deductions for individuals, generally up to 50% of adjusted gross income. Taxpayers who donate assets to charitable or educational organizations can deduct the 
assets' full value without any tax on appreciation.Corporations can also deduct charitable contributions, up to 10% of their pretax income.
The basic principle behind the tax deduction for charitable donations is a defensible one: people shouldn't be taxed on income that doesn't benefit them personally, but that they instead give away for the public good. (This is the same as the rationale for the deduction for state and local taxes.)In other words, if someone earns $1,000 and gives it away to charity, it's reasonable not to tax him on that $1,000 in earnings. The normal way it works in the case of cash gifts is that the donor includes the $1,000 in his gross income and deducts the $1,000 gift in computing taxable income.Net result: no tax on the income given to charity.
But there are major problems with charitable deductions, most notably in the case of donations of property rather than cash. In 1986 (the last year before the 1986 Tax Reform Act took effect), the IRS says that one out of every ten people making more than $200,000 who paid no federal income tax at all reported giving more than 30% of total income to charity. A few of these no-tax rich people said they donated all of their income to charity.If this looks a little fishy to you, you're right. Almost certainly, much of this apparent largesse reflected a loophole in the law that allowed these wealthy people to deduct the full appreciated value of donated property,even though the increase in value was never counted as part of their gross income.
Take someone who has $1,000 worth of stock that she originally bought for$100. If she sells the stock and gives the $1,000 to charity, she'll include the $900 gain in her gross income and get a deduction for the donation.The net tax on the income given to charity will be zero. Fair enough.
Suppose, however, that instead our taxpayer gives the stock itself directly to charity. That shouldn't end up with a different bottom-line tax result.After all, there's no real distinction. But under the
regular income tax rules, there's a huge difference. Not only will she get a deduction for the $100 in earnings originally used to buy the stock, but she'll also get a deduction for the $900 in appreciation that is not included in her adjusted gross income. As a result, she won't have to pay taxes on $900 of her other income that she did not give to charity.
Thus, in this example, someone in the 28% tax bracket will be $252 better off by donating the stock directly rather than selling it and giving away the proceeds. This strange result is the equivalent of allowing someone who sells the stock and makes a cash gift to take a double deduction for the stock's increased value.
The problem can be even worse in the case of donations of hard-to-value property, such as works of art. Too often, taxpayers will assert highly-inflated"values" for donated objects, and take tax deductions for the full so-called "market value." Congenial or unscrupulous private appraisers sometimes assist in this tax avoidance. - A few years ago, for example, the curator of the Smithsonian Museum was caught cooperating in a scam in which wealthy taxpayers took huge deductions for donations of gems that were appraised at thousands of times their real value. From the curator's point of view, nothing was amiss. The scheme was arranged so that occasionally the Smithsonian would get a donation with real value. But it ended up (before the fraud was exposed) that the cost to the government in lost revenues was far greater than the real value of what the Smithsonian received.
Of course, the IRS tries to police the phony-appraisal area, but with an audit rate of less than 2%, it can't deal with most cases of abuse.24
Although often criticized, the loophole for donations of appreciated property was a fixture in the tax code for many years. In 1986, however, the Tax Reform Act limited these excessive charitable deductions in connection with the alternative minimum tax--which is supposed to assure that all high-income people pay at least some significant federal income tax no matter how many tax preferences they may utilize under the regular tax. After 1986, in computing taxable income under the minimum tax, taxpayers who made charitable donationsof appreciated property no longer got better treatment than cash donors.Instead, they could deduct only what they paid for the donated property--beit stocks, real estate or whatever. The General Explanation of the 1986 Act explained the reasons for the reform as follows:
"Congress concluded that certain items . . . must be added to the minimum tax base in order for it to serve its intended purpose of requiring taxpayers with substantial economic incomes to pay some tax. The items . . . include. . . untaxed appreciation deductions with respect to charitable contributions of appreciated property."
Unfortunately, in 1993 the Clinton administration persuaded Congress to restore the old tax shelter by repealing the 1986 minimum tax reform.25 This tax deform substantially weakened the minimum tax and will increase the number of wealthy tax freeloaders.
At bottom, the appreciated-property-donation tax break amounts to an open-ended,essentially unpoliced entitlement program for rich donors. It encourages fraud and undermines tax fairness.
In the case of donations of tangible property such as artworks, the government ends up helping pay for things that it might otherwise never have considered subsidizing. If the federal government has extra money available to subsidize art-museum acquisitions, it should appropriate the funds directly--and make sure that the funds are well spent. Meanwhile, the appreciated -property-donation loophole should be closed.
Medical expenses. Personal out-of-pocket outlays for medical care(include ing the costs of prescription drugs) exceeding 7.5% of adjusted gross income are deductible. The rationale for the
deduction is that extraordinary out-of-pocket medical expenses reduce a family's ability to pay taxes.
Because of the floor, only about one in twenty-three taxpayers utilizes this deduction in any given year. A family with income of $50,000, for example,can deduct only medical expenses above $3,750. Because of the floor (and because a third of the families who do take the medical deduction would otherwise use the standard deduction), the average subsidy rate is quite low, only about 8% of the extraordinary medical expenses claimed. About half of the total tax savings go to families making between $30,000 and$75,000. In this group, one out of 14 taxpayers claims the deduction. Their average medical expenses are about $8,000, with about $4,700 of that deductible.Their average tax saving from the deduction is $620.
Casualty losses. People who buy property and casualty insurance can't deduct its cost. But unlucky or poor-planning families who suffer a largeuninsured loss due to casualty or theft can
sometimes deduct such a loss --but only if their total losses during a year are more than 10% of their adjusted gross income (and if they itemize deductions). Because of the floor, very few families take the casualty loss deduction (only 121,699 did so in 1992). The number taking the deduction and its cost to the Treasury seem to fluctuate depending on the level of natural disasters in a year.
Although the casualty loss deduction could have some appeal on ability-to-pay grounds (similar to the deduction for extraordinary medical expenses),one can reasonably ask whether what amounts to a government back-up to the private property insurance system makes much sense.
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