In 2011, thirty one states and the District of Columbia allow a group of income tax breaks known as “itemized deductions” (Figure 1). Itemized deductions are designed to help defray a wide variety of personal expenditures that affect a taxpayer’s ability to pay taxes, including charitable contributions, extraordinary medical expenses, mortgage interest payments and state and local taxes. These deductions cost states billions of dollars each year while providing little or no benefit to the middle- and low-income families hit hardest by the lingering economic downturn.
The so-called Bush tax cuts enacted in 2001 at the behest of President George Bush and extended in late 2010 for tax years 2011 and 2012 under President Barack Obama are most widely known for cutting the top income tax rate to 35 percent. But they also quietly repealed the “Pease” disallowance — a provision named after its Congressional sponsor — that reduces the cost and regressivity of certain itemized deductions by limiting their value by up to 80 percent for the very best-off taxpayers. Pease gradually disappeared between 2006 and 2009, with full repeal coming into effect for the first time in 2010. Before the first round of the Bush tax cuts were enacted in 2001, every state with itemized deductions other than California had adopted the federal Pease disallowance—which means that these states saw their version of Pease disappear as the Bush tax cuts were gradually phased-in.
The tax compromise package passed at the end of 2010 extended the repeal of Pease for an additional two years — into 2011 and 2012. This federal tax cut will likely be passed through to most state tax laws, reducing state income tax collections in the 31 states allowing federal itemized deductions by more than $2 billion annually (California is the exception, since it has its own stand-alone disallowance provision similar to Pease). As a result, many of the wealthiest taxpayers in those states will receive automatic state tax cuts over the next two years. Fortunately, state lawmakers can “decouple” from this provision of the tax compromise package by creating their own limits on the value of itemized deductions (See Appendix I for state-by-state estimates of decoupling from the
Federal Pease repeal in tax year 2011).