How Congress Can Cap Tax Breaks

By :: August 11th, 2011

Sooner or later, Congress will realize it needs new revenues to help balance the budget, and trimming tax subsidies is the way to get them.  But will it tackle individual preferences, such as the mortgage interest deduction, one at a time? Or, will it try to limit the political bloodshed and go after these tax breaks across-the board?

The Tax Policy Center has looked at three ways to limit the benefit of tax subsidies for high-income households. Each would raise billions in new revenues—money that could be used to both reduce the deficit and cut tax rates. And each would be quite progressive. However, they’d work very differently.

The first is the Obama Administration’s proposal to cap the value of itemized deductions at 28 percent. The second, called the Effective Minimum Tax, would require high income households to pay a rate of at least 21 percent on their Adjusted Gross Income (AGI) plus municipal bond income. The third is a modified version of a plan offered by Marty Feldstein, Dan Feenberg, and Maya MacGuineas that would limit the value of deductions and credits to 2 percent of AGI. Let’s take a look at each of them.

The Obama plan would raise about $165 billion over 10 years (I’m comparing each plan to current policy--that is, the taxes people pay today). According to this proposal, those in the 33 percent and 35 percent brackets could take all the same itemized deductions they do now, but their value would be capped at just 28 percent.  

Obama would raise taxes on about 5.4 million housholds. About 95 percent of the new taxes would be paid by the highest-income 5 percent of households, although a handful of middle-class people would  also get clipped. The average tax hike in 2013 would be about $2,800, and the top 0.1 percent would pay an average of about $54,000 more than they do today.

The Effective Minimum Tax (EMT) was developed by TPC’s Jim Nunns. It would operate something like the alternative minimum tax but would be imposed on a broader tax base and affect only top-bracket taxpayers. They'd figure their regular tax, calculate their EMT rate, and pay the higher of the two. This levy would raise about $170 billion over 10 years.  Only about 400,000 households--all in the top 5 percent--would pay more tax. And they'd owe an average of $80,000 more. Those in the top 0.1 percent of income would pay much more than under the Obama plan—an average tax increase of more than $400,000.

This tax, like the others, assumes the existing Alternative Minimum Tax remains on the books. But in the real world, if the EMT is enacted, I suspect the AMT would be repealed. If so, the plan would either have to impose a higher EMT rate or hit more middle-income taxpayers to generate the same amount of money.   

Limit Tax Breaks to 2 Percent of AGI. The third broad cap on tax breaks is based on a plan designed by Harvard economist Marty Feldstein, Dan Feenberg at the National Bureau of Economic Research, and Maya MacGuineas of the New America Foundation. While they would have capped the value of most tax preferences at 2 percent of AGI for all taxpayers, TPC targeted the cap only at high-income households so we could better compare it to the other two plans.

Importantly, while Obama would target only deductions, this proposal taxes a much broader base. The 2 percent limit would also apply to the value of employer-sponsored health insurance, the child and dependent care tax credit, and general business tax credits.

Even scaled back to include only high-income households, this plan would generate twice as much money as the other two—more than $500 billion over 10 years. About 2.8 million housholds would pay more, and the average tax increase would be about $16,000. The top 0.1 percent would pay about $240,000 more.

These are just three examples of how Congress could tackle the $1 trillion in tax expenditures without battling over each one individually.  In an ideal world, Congress would address each on their economic merits. But, this is Washington, and I wouldn’t be surprised to eventually see an across-the-board plan surface. And it is likely to look like one of these.

6Comments

  1. Michael Bindner  ::  5:09 pm on August 11th, 2011:

    The other option is across the board tax reform, with consumption taxes like the FairTax or a Value Added Tax paired with a Net Business Receipts Tax replacing corporate income taxes, personal income tax collection of business taxes and some payroll taxes (if not all payroll taxes) – or you could leave the payroll and corporate taxes in place and broaden the corporate tax base. You would then retain a simplified income tax on high incomes with very few deductions. The NBRT would have some deductions, but these could be limited to the health insurance exclusion and a subsidy for families.

    When you start with a clean slate, you don’t eliminate deductions – they must be added back.

    The tax break limit by MacGuinness and Feldstein would be horribly regressive – you simply can’t assume away how this would savage low income tax breaks for the sake of comparisons.

  2. Reconciliation « Tax Australia  ::  10:08 pm on August 11th, 2011:

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  3. AMTbuff  ::  12:00 am on August 12th, 2011:

    I suppose all the non-sneaky options, such as repealing deductions outright, are off the table?

    I find the continuation, let alone the expansion, of opaque tax increases disgusting. Taxpayers will too. If there’s one thing more unpleasant than a tax increase, it’s a sneaky tax increase.

    Want to repeal the deduction for state and local income taxes? Just do it. Don’t play the game of repeal the deduction for the other party’s voters without repealing it for our party’s voters. Sneakiness discredits the tax code and reduces voluntary compliance. Nobody of either party in Congress seems to care.

    In my opinion the sneakiness of the proposed approaches pays tacit homage to the legitimacy of the deductions being limited. These approaches are clever but intellectually dishonest. They violate fundamental principles of horizontal equity, for example by taxing gross income rather than net income. In most cases net income is a better measure of true economic reality.

  4. phr3dly  ::  3:56 am on August 12th, 2011:

    One of the primary reasons for the inefficiency of our tax system, and its unintended consequences, is its complexity.

    These proposals all add considerable complexity. They are popular with politicians, because they appear to raise other people’s taxes.

    Here’s a better approach. Start getting rid of tax deductions. The poor generally don’t benefit from them anyway, because they don’t itemize. The middle-class get only a small benefit, if any. The highest earners benefit the most from them.

    As a “high earner” who is generally in favor of lower taxes, I would be pleased to see any changes that simplify the tax code.

  5. Ralph H  ::  8:56 am on August 12th, 2011:

    People hate the complexity of the current code. To put in a 3rd (EMT) way of calculation is nuts! All these proposals will substantially make the tax preparation more difficult. What most people want is some simplification, hopefully at a lower rate. In general most of the states have done this with low rates that seem to cover a broader range of income. Why not eliminate tax free municipals? Just stop issuing them from 2012 on. problem solved over time.

  6. Gerhard Randers-Pehrson  ::  1:10 pm on August 12th, 2011:

    Let me put a new proposal on the table and invite you to analyse it.
    The tax return would have three parts:
    1) The first part lists the full value of ALL income with NO deductions. The tax on this amount is computed.
    2) The next part lists all subsidized expenditures like home mortgages, state taxes, one-half of capital gains, etc. The tax on this amount is computed.
    3) the third part lists items that are presently treated as tax credits. The sum of these items is computed.
    The tax due is part1 minus part2 minus part3. This scheme is simple and fair. It also makes it clear that tax breaks are expenditures designed to subsidize certain activities.