Elective Efficiency: Itemizing Our Way to a More Optimal Income Tax

Emily A. Satterthwaite, University of Toronto Faculty of Law

Abstract

This article offers a new explanation of the poorly-understood phenomena of elective provisions in tax law. Despite its well-recognized horizontal equity rationale, I argue that the choice offered to individual taxpayers in the U.S. to itemize their deductible expenses increases the efficiency of the income tax. For taxpayers with lower incomes, the election to itemize acts as a screen that reveals the taxpayer’s unobservable cost-type to the government and allows the income tax to be more optimally “tailored” in the direction of a first-best lump sum tax by lowering itemizers’ marginal tax rates. I show that the elective standard deduction introduced in 1944 can be viewed as a mechanism that bolsters the screening function of the election by reducing the itemizing propensity of would-be tax avoiders and low-ability taxpayers on the boundary between itemizing and not itemizing, while saving government enforcement and taxpayer compliance costs. Additionally, I argue that one of the drawbacks of using elective provisions such as itemization to optimally tailor the income tax—deliberation costs borne by lower-income taxpayers who are uncertain about whether they should make the election—can be mitigated by structuring the election within a real option framework. This tailoring and real option analysis suggests that little-noticed details of elective provisions in the law may have more important effects on their efficiency than previously recognized.