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Morgan Stanley Explains How Rich New Yorkers And Californians Could Get Really Screwed In A Fiscal Cliff Deal


Ducks in Central Park

Obama wants the rich to pay more taxes than they are right now.

Boehner is okay with the government collecting more revenue, but is against any hike in rates.

So the hot idea is that a compromise might be worked out by limiting deductions that the wealthy take, a plan that was vaguely floated by Mitt Romney.

In a note, Morgan Stanley economist David Greenlaw explains how this works:

...When preparing their returns, taxpayers may choose the standard deduction or they may itemize and deduct certain expenses (including state and local taxes, mortgage interest, charitable contributions, and some medical expenses) to determine their taxable income. Taxpayers benefit from itemizing when their itemized deductions exceed the amount of the standard deduction. Note that for some types of expenses (such as medical expenses), only the amount that exceeds a given percentage of the taxpayer’s adjusted gross income may be deducted.  So, there is already a limitation imposed on certain types of deductions.  But, with all other deductions, the benefit of itemizing increases with a taxpayer’s marginal tax rate. For instance, $10,000 in deductions reduces tax liability by $1,500 for someone in the 15 percent tax bracket but by $2,800 for someone in the 28 percent tax bracket.

So how does this actually affect individuals?

Reverting to pre-Bush tax rates on incomes above $250,000 – as the President and many Democrats have long advocated – would raise about $1 trillion over the next ten years.  In order to achieve approximately the same amount of deficit reduction, the limitation on deductions would have to be set at 15%.  In other words, taxpayers in marginal tax brackets above 15% would lose some of the benefit of their itemized deductions.  Obviously, such a change would have the greatest impact on taxpayers in high brackets with a lot of deductions.  In particular, the limitation on deductions would hit taxpayers in high tax states – such as NY and California – particularly hard

Because state and local taxes are deductible, limiting deductions really creams rich taxpayers in places with high taxes.

And unfortunately, this probably reduces the odds of a deal, given how much clout people in both of those states.

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