The House reconciliation bill’s 3 percent surtax has a broader base than the regular income tax

By Alan D. Viard

The budget reconciliation bill recently assembled by the House Budget Committee includes numerous tax increases on high-income households. One novel provision (section 138206) calls for a new 3 percent surtax on adjusted gross income (AGI) in excess of $5,000,000, which would be added on to the affected taxpayers’ other taxes. The surtax, which disallows some of the deductions allowed under the regular income tax, is superior in some, but not all, respects to an increase in the affected taxpayers’ regular income tax rates.

AGI, which is used to compute the surtax, is a broader tax base than taxable income, which is used to compute regular income tax liability. The key difference is that itemized deductions, such as mortgage interest, state and local taxes, and charitable contributions, are not allowed in the computation of AGI. Introducing an AGI surtax rather than raising regular income tax rates precludes the affected taxpayers from reaping bigger tax savings from their itemized deductions.

The treatment of owner-occupied housing is more efficient under the surtax than it would have been under an increase in regular income tax rates. Raising the regular tax rates would have enabled the affected taxpayers to obtain bigger tax savings from their mortgage interest payments, which would have amplified the distortionary incentive for these wealthy taxpayers to buy bigger and more expensive houses. Because the surtax disallows the mortgage interest deduction, it does not amplify that distortion.

The disallowance of the state and local tax deduction under the surtax is also probably desirable in view of the weighty arguments against the deduction. However, that feature will not really matter until 2026 because the regular income tax imposes a tight cap, slated to expire at the end of 2025, that essentially eliminates the state and local tax deduction for high-income taxpayers.

One feature of the surtax may be controversial. Raising regular income tax rates would have enabled the affected taxpayers to obtain bigger tax savings from their charitable contributions, strengthening their incentive to give. Because the surtax disallows the charitable deduction, it offers no additional giving incentives. Of course, the surtax does not impair the affected taxpayers’ existing incentives to give. Moreover, these taxpayers already have bigger incentives to give than other taxpayers — because they are in the top tax bracket, they receive the largest tax savings for each dollar they give.

Due to a special rule, one important itemized deduction is available under the surtax. Like the regular income tax, the surtax allows a deduction for investment interest expense (up to the amount of investment income). It would be inappropriate to tax the returns from investing borrowed money without a deduction for the borrowing costs.

Another deduction should, but does not, enjoy a similar dispensation. Although the regular income tax allows a deduction for gambling losses (up to the amount of gambling winnings), the surtax does not. Under the surtax, winnings are taxed with no deduction for offsetting losses, an inappropriate policy.

Although it has some advantages over an increase in the affected taxpayers’ regular income tax rates, the House reconciliation bill’s AGI surtax is far from ideal. The impending debate over the proposed surtax offers a valuable opportunity to reexamine the role of itemized deductions in the tax system.

Alan D. Viard is a senior fellow at the American Enterprise Institute.