For Washington residents, I-1098 defines taxable income to be adjusted gross income (AGI) as calculated at the bottom of the first page of the federal 1040 income tax form less interest received on federal obligations (which the state is prohibited from taxing). The deductions that are itemized on Schedule A and entered on the second page of federal form 1040 are not allowed. Thus, taxpayers will not be able to deduct a number of items, including home mortgage interest and charitable contributions, that are deductible for the federal income tax.

Deductions in the calculation of the Federal income tax

Deductions enter into the calculation of a taxpayer’s federal income tax liability in two places on form 1040. Deductions for 13 specific items are taken on the first page. (Among these page 1 “adjustments” are educator expenses, health savings account deposits, moving expenses, self-employed pension and health insurance expenses, alimony paid, IRA deposits, student loan interest, and tuition.) The total of these deductions is subtracted from the taxpayers total income to get adjusted gross income.

Deductions for other items are itemized on Schedule A. Among the items deductible on Schedule A are medical and dental expenses, home mortgage and investment interest payments, charitable gifts, unreimbursed employee expenses and investment management fees. On page 2 of form 1040, the taxpayer subtracts from AGI exemptions and either itemized deductions or the standard deduction to calculate taxable income (TI).

The value of the itemized deductions that transform AGI into taxable income is much greater than the value of the statutory adjustments that transform total income into AGI.  Here are numbers from the IRS’s summary of national returns for 2008: AGI, $7.58 trillion; page 1 statutory adjustments, $99.6 billion; standard deductions, $376.3 billion; Schedule A itemized deductions, $1.13 trillion. For 2008 federal taxpayers with AGI exceeding $500,000, state and local taxes were 48 percent of itemized deductions; charitable contributions were 23 percent, mortgage interest was 9 percent; and investment interest was 8 percent.

As this table from the Center on Philanthropy at Indiana University shows, taxpayers with income above $200,000 contribute disproportionately to health organizations, education institutions and the arts, while taxpayers with incomes below $100,000 contribute disproportionately to religious causes.

Deductions in the calculation of state income taxes

Forty-three states impose income taxes. In two cases (New Hampshire and Tennessee) the tax is narrow, applying only to dividend and interest income. For most of the 41 states with broad income taxes, the calculation of state income tax liability closely parallels the calculation of federal liability. Thirty-two states start with AGI from the taxpayer’s federal form. Three states start with taxable income from the federal form, while the remaining 6 states do not reference federal AGI or taxable income.

Those starting with federal AGI or taxable income make various additions or subtractions to the number taken from the federal return. The most common addition is interest on out-of-state state and municipal bonds. All state subtract from AGI or TI interest on federal bonds. Most subtract the portion of social security income that is subject to federal taxation. Many states subtract a portion of pension income. Some states subtract the portion of unemployment compensation that is included in AGI.

Thirty-two of the income tax states allow itemized deductions that largely mirror those on the federal Schedule A, including the deductibility of  charitable contributions and home mortgage interest. This is summarized on this table,  which is reproduced from this report by the Wisconsin Legislative Fiscal Bureau. In the table, the entry “federal” indicates that deduction of the item follows the federal practice, “state” indicates that the deduction follows state-specific rules.

Nine of the income tax states do not provide itemized deductions for either interest expenses or charitable contributions, with these minor exceptions. These states are Connecticut, Illinois, Indiana, Massachusetts, Michigan, New Jersey, Ohio, Pennsylvania and West Virginia. All but New Jersey and Pennsylvania provide the federal student loan interest deduction. Michigan provides a deduction for distributions from pension or retirement accounts that are contributed to a charity, so long as those distributions are included in AGI. New Jersey provides a deduction for Qualified Conservation Contributions. Indiana provides a tax credit of up to $100 ($200 for joint returns) for contributions to a college or university located in the state and a parallel credit for contributions to a state scholarship program (the Twenty-First Century Scholars Program).

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