Why the 'fiscal cliff' deal is an incentive to give to charity

The "fiscal cliff" deal's phaseout of itemized deductions is really a sneaky way to raise marginal income tax rates and creates an economic incentive to give to charities, Burman writes.

Bob Wellinski/The LaPorte Herald-Argus/AP/File
Vincent, 4, and his sister, Alana, 2, put money into the Salvation Army kettle as part of The Salvation Army’s 121st Red Kettle Campaign in LaPorte, Ind., in this November 2012 file photo. The "fiscal cliff" deal provides an economic incentive for donating to charity, Burman writes.

Huffington Post reports on this tweet/warning from former Bush press secretary, Ari Fleischer:

I increased donations to charity in 2012. This deal limits my deductions so I, & many others, will likely donate less in 2013.

Mr. Fleischer is referring to the phaseout of itemized deductions, which had temporarily expired but was reinstated by the Tax Relief Act of 2012 (the official name for the deal that averted the fiscal cliff).  Fleischer expanded on this point in an op ed in the Wall Street Journal.

Fleischer is wrong,  but it’s easy to understand why he might be confused since the phaseout is designed to obfuscate.  Here is the main point:  Even though it is called a phaseout of deductions, it’s really just a sneaky way to raise marginal tax rates by a little over 1 percentage point on high-income people. 

The phaseout works this way.  Singles with incomes over $250,000 and couples with incomes over $300,000 lose 3 cents of itemized deductions for every dollar of income above the threshold.  If Mr. Fleischer is married and makes $500,000, his itemized deductions are reduced by $6,000 (3% of the $200,000 of income above $300,000).  If he earns more money, his deductions will continue to be reduced.  The law limits the phaseout to 80% of deductions, but almost nobody hits that limit because deductions tend to increase with income.  Think state and local taxes and charitable donations, which are much more than 3% of income for almost everyone with higher income. 

But what does this do to the tax benefits of charitable giving?  If Mr. Fleischer is considering giving another $10,000 to some worthy cause (or even an unworthy one, so long as it’s a 501(c)(3)), his deductions will increase by that $10,000.  The amount of the phaseout is unaffected, since it depends only on income, not the total amount of deductions (except for that miniscule fraction of taxpayers at the limit).

Assuming he is in the 39.6% bracket, he will save $3,960 in federal income taxes (and more in state income taxes).  That is an increase of $460 from 2012 when the top rate was  35%.  So the new law increases the tax incentive to give by raising his marginal tax rate (and making deductions more valuable).

The phaseout is really a sneaky way to raise marginal income tax rates.  Suppose Mr. Fleischer earned another $10,000. He would lose $300 of itemized deductions (3% of $10,000), so his taxable income (AGI minus deductions) would increase by $10,300, not $10,000.  Again, assuming he is in the 39.6% bracket, his additional tax would be $4,079 (39.6% of $10,300), so his effective tax rate is 40.8%, not 39.6%.

So he might decide to pass up on a speaking gig because he thinks the tax hit is too high.  Or he might decide to work a little more so he can maintain the same level of consumption that he did before the tax increases.

But he has a stronger incentive than ever to give to charity.

Disclaimer: I have no idea what Ari Fleischer’s income or marital status is. The numbers above are simply provided as an example.

Len Burman is coauthor with Joel Slemrod of Taxes in America:  What Everyone Needs to Know.

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