Trimming Tax Breaks to Cut Rates is a Lot Harder Than It Looks

By :: July 10th, 2012

It won’t be impossible for pay for substantial individual tax rate reductions by cutting tax expenditures. But it will be very, very hard.

The challenges are political, administrative, economic, and, in a key way, mathematical. While “broadening the base and lowering the rates” is a goal often advanced by politicians and economists, a new study by my Tax Policy Center colleagues Jim Nunns, Bob Williams, Eric Toder, and Hang Nguyen  shows just how tough it would be to accomplish.

One of the biggest and least understood challenges is the interaction between rates and tax preferences. In short, deductions, exemptions and the like lose their value as rates fall. Thus, the very act of cutting rates shrinks the pile of money Congress has available to pay for those rate reductions.

To understand why, first think of it first from the taxpayer’s point of view.  A $100 tax deduction is worth $35 to a taxpayer who is in today's top bracket of 35 percent, but would be worth only $28 if that rate is cut to 28 percent.  From government’s perspective (to oversimplify a bit), eliminating that deduction would produce $35 today but only $28 if rates are cut.

To see what this means, my TPC colleagues looked at what would happen if Congress slashes individual tax rates by 20 percent across the board and eliminates the Alternative Minimum Tax, two elements of a much broader tax reform proposed by Mitt Romney.

As a result, the Treasury would collect about $320 billion less in individual income taxes in 2015 than under today’s tax rules (aka current policy). Thus, if Congress wants to generate the same amount of revenue,  it would need to reduce individual tax expenditures by $320 billion (Of course, it could find the money elsewhere—say, by cutting spending or raising corporate taxes-- but that’s another story).

The math is unforgiving. By lowering rates Congress reduces the total value of individual tax preferences by about $200 billion—from $1.3 trillion under current policy to less than $1.1 trillion. And that means it would need to cut those tax expenditures by nearly one-third ($320 billion out of $1.1 trillion) to make up the revenue lost by the tax cuts.

If Congress wants to generate the same amount of money as current law, the hole would be much deeper. Lawmakers would have to cut tax preferences by $730 billion.

In the real world, coming up with those bucks is even harder than that. Because many of these tax subsidies are deeply ingrained in the economy, Congress is likely to phase them out slowly. In addition, taxpayers will adjust their own behavior in response to these tax changes. Both would further reduce the amount of revenue from base-broadening.

Then, there is the matter of what is administratively and politically feasible.

To sort through this, TPC divided tax expenditures into four buckets—each less likely than the next to face cuts. The first, where changes are most likely, comprises preferences such as itemized deductions and non-retirement fringe benefits. This includes popular deductions for mortgage interest, charitable gifts, and the exclusion for employer-sponsored health insurance so scaling these back would be a heavy lift. But curbing other preferences would be even tougher.

The second group includes investment and savings incentives such as low rates for capital gains and preferences for contributions to retirement accounts. The third tranche includes credits for low-income families with children and the partial exclusion of Social Security benefits. The last pot--and most untouchable-- are exclusions for income such as imputed rent on owner-occupied housing and combat pay.

TPC figures that if all of the offsetting revenues came from Group 1 only, those tax preferences would have to be slashed by 72 percent to prevent the rate cuts from adding to the current policy deficit (assuming people don’t change behavior).

Just as vexing, if Congress cuts that bundle of tax breaks across the board while trimming rates by 20 percent and eliminating the AMT, the Tax Code becomes much less progressive. On average, the highest-income 5 percent would pay less tax while those in all other income groups would pay more.

About the only way Congress could fix that huge distribution problem would be to raise tax rates on capital gains and dividends—an idea strongly opposed by Romney and most congressional Republicans.

Broadening the base and cutting tax rates is a great idea. But the message from this paper is simple: It sounds a whole lot easier than it is.

 

19Comments

  1. Annette Nellen  ::  3:13 pm on July 10th, 2012:

    Thanks for the report!

    I think those calling for cut back or elimination of tax expenditures need to start educating the public on at least three aspects of tax expenditures:
    (1) This is a form of spending that is close in amount to discretionary spending in the federal budget. So those advocating for cutting spending need to look at tax system spending as well.
    (2)The dollars associated with many tax expenditures are distributed in a way that most people would not tolerate if part of the “regular” budget. For example, spending $90 billion annually for the 1/3 of filers who itemize to help them afford a more expensive home or even a vacation home, would unlikely be tolerated. Yet, when hidden and not well described in the tax law, people love it. Or, if described accurately in the budget, people might ask for that $90 billion to be distributed (spent) more equitably. (Similar results would likely occur for the $200 billion+ for the exclusion for employer-provided health insurance.)
    (3)Special deductions, exemptions and credits support high tax rates and a complicated tax system. Cutting back will help get to low rates and a simpler system.

    It would also be nice to see those advocating for lower corporate tax rates and lower capital gains and dividend rates to talk about corporate integration and how to pay for it all. To discuss these topics separately and without a discussion of how all businesses should be taxed is not productive.

  2. Vivian Darkbloom  ::  4:29 pm on July 10th, 2012:

    “To understand why, first think of it first from the taxpayer’s point of view. A $100 tax deduction is worth $35 to a taxpayer who is in today’s top bracket of 35 percent, but would be worth only $28 if that rate is cut to 28 percent. From government’s perspective (to oversimplify a bit), eliminating that deduction would produce $35 today but only $28 if rates are cut.”

    This is not only overly-simplistic; it strikes me as the wrong way (backwards) to look at the issue. In essence, it is being suggested here that the correct way to view the tax revenue raised by eliminating a deduction is to measure that against a contemporaeously implemented lower marginal tax rate rather than current law.

    Assume a taxpayer has $100 of income and a $10 deduction at the current marginal rate of 35 percent. The pre-deduction tax is $35, the value of the deduction is $3.50 and the net tax is $31.50.

    Now, assume that marginal rate is reduced to 28 percent and the deduction is eliminated. The net revenue decrease from the rate reduction is $7 and the net tax is $28. The net difference in revenue is $3.50 revenue gained from eliminating the deduction against $7 lost from reducing rates for a net revenue loss of $3.50. How the revenue gain from *elimination* of a deduction is affected by the contemporaneous reduction in marginal rates escapes me.

  3. AMTbuff  ::  9:16 pm on July 10th, 2012:

    Vivian, the article’s assumption was stated: “If Congress wants to generate the same amount of money as current law…”

    In your example, revenue declined by $3.50. To erase that decline another $10 of deductions would have to be eliminated or the rate would have to be 31.5% instead of 28%.

    I agree with Howard’s math. Total revenue is the correct metric. However does that mean that it’s “harder than it looks” to achieve revenue neutrality? Not unless you took the obviously incorrect shortcut of using the old tax rates when estimating revenue gains from eliminating deductions.

    It’s also obviously incorrect to ignore changes in taxpayer behavior, as TPC did, especially when we tout those changes as a benefit of eliminating deductions. Call me a cynic, but I suspect that TPC would have tried to account for changes in taxpayer behavior if those changes were thought to decrease rather than increase revenue. Due to behavior changes the TPC’s 72% estimate is too high, but 97% of readers (84% of statistics are pulled out of the air) will not realize this.

    Howard’s reasoning is sound, but by all means feel free to disagree with his “harder than it looks” characterization if your economic vision is clear.

  4. Vivian Darkbloom  ::  5:01 am on July 11th, 2012:

    AMT,

    I thnk you are missing my point, even though the following seems to have grasped it:

    “In your example, revenue declined by $3.50. To erase that decline another $10 of deductions would have to be eliminated or the rate would have to be 31.5% instead of 28%.”

    This has nothing to do with the assertion that the value of a deduction is reduced if the rate drops to 28 percent. In fact, your sentence above suggests (correctly, I think) that the additional reduction of $10 is worth $3.50 in revenue rather than the $2.80 that I think Howard’s logic is suggesting. In fact, the deduction was eliminated, so it is now worth nothing, much less 28 cents on the dollar.

    Of course, if you eliminate a deduction and want to lower rates at the same time, the amount you save by eliminating the deductions affects how much you lower rates-see your own comment above after the “or”.

    What we are talking about, presumably, is what the options would be in a grand tax bill that addresses both deductions and rates in one go. Howard’s logic only makes sense to me if the thing is done in two stages: In stage 1, rates are lowered without any consideration as to what deductions might be eliminated to make up the difference. Then, in stage two, presumably in a later bill, one thinks about eliminating deductions. Then, and only then, would it make sense to me to say that eliminating a deduction to raise revenues is made more difficult through reducing rates.

  5. Tax Roundup, 7/11/2012: « Roth & Company, P.C  ::  9:13 am on July 11th, 2012:

    […] it doesn’t look easy: Trimming Tax Breaks to Cut Rates is a Lot Harder Than It Looks (Howard Gleckman, […]

  6. Why Romney’s Plan Could Mean Higher Taxes for All but the Richest | John Metz's blog  ::  5:56 pm on July 11th, 2012:

    […] That leaves a handful of big tax spending items, such as deductions for home mortgage interest, charitable contributions, state and local taxes, medical expenses, and more. Romney would have to reduce these kind of tax spending items by 72 percent ”to prevent the rate cuts from adding to the current policy deficit (assuming people don’t change behavior),” Howard Gleckman at TPC writes. […]

  7. Michael Bindner  ::  9:41 pm on July 11th, 2012:

    I favor an answer that consolidates tax breaks, for instance combining the child exemption, the EITC, the Child Tax Credit, the Home Mortgage Deduction, the Property Tax Deduction and the SNAP program into one refundable deduction that is paid with wages or training stipends and does not have a ceiling. It would be against an employer consumption tax, not a personal income tax.

    The next stage is to keep dividend tax special rates in harmony with capital gains rates, letting the latter go to 25% as scheduled. Meanwhile, the 35% rate stays where it is until tax reform happens – with the price of lower rates being the acceptance of some kind of consumption tax system and the exclusion of most people from any income taxation. Inherited income would be taxed as normal income when the asset is sold, not when it is recieved, with the entire proceeds of the sale being taxable after the income tax level. A fairly deduction free system of income taxation will keep other deductions off.

    It is easier to get rid of breaks if an entirely new system is put together and interests must get added rather than repealed. A consumption tax system with VAT and VAT-like net business receipts taxes (which is a VAT with exclusions) makes it harder to put in profit based exclusions.

  8. Why Romney's Plan Could Mean Higher Taxes for All but the Richest  ::  3:24 pm on July 12th, 2012:

    […] That leaves a handful of big tax-spending items, such as deductions for home mortgage interest, charitable contributions, state and local taxes, medical expenses, and more. Romney would have to reduce these kind of tax spending items by 72 percent “to prevent the rate cuts from adding to the current policy deficit (assuming people don’t change behavior),” Howard Gleckman at the Tax Policy Center writes. […]

  9. Around The Dial – July 19, 2012 | South By North Strategies, Ltd.  ::  3:08 pm on July 19th, 2012:

    […] TaxVox points out how hard it is to broaden the tax base. […]

  10. Joe M.  ::  6:38 am on July 23rd, 2012:

    “As a result, the Treasury would collect about $320 billion less in individual income taxes in 2015 than under today’s tax rules (aka current policy). Thus, if Congress wants to generate the same amount of revenue…”

    The whole idea of cutting taxes comes from the side of the political aisle that want’s a smaller, limited government as designed by the founders. Yet, here you are, in all your fascinating intelligence, discussing what it would take to keep government as large as now while cutting taxes. It’s as if you are completely tone deaf.

    We want to cut taxes to force the issue that gov’t needs to be smaller. The discussion needs to be about how much more earning potential there will be for all when government programs are cut in accordance with tax cuts. To put in your languaage, you “pay” for taxcuts by cutting government programs! sheesh!

  11. Mitt Romney’s other tax secret  ::  6:47 am on July 23rd, 2012:

    […] reductions by cutting tax expenditures,” Howard Gleckman, the editor of TaxVox, wrote in a blog post. “But it will be very, very […]

  12. Mitt Romney’s other tax secret | Free PR Online  ::  8:18 am on July 23rd, 2012:

    […] reductions by cutting tax expenditures,” Howard Gleckman, the editor of TaxVox, wrote in a blog post. “But it will be very, very […]

  13. Mitt Romney's other tax secret – All About Forex Market | All About Forex Market  ::  11:12 am on July 23rd, 2012:

    […] reductions by cutting tax expenditures,” Howard Gleckman, the editor of TaxVox, wrote in a blog post. “But it will be very, very […]

  14. Mitt Romney's other tax secret | Xtax  ::  1:44 pm on July 23rd, 2012:

    […] reductions by cutting tax expenditures,” Howard Gleckman, the editor of TaxVox, wrote in a blog post. “But it will be very, very […]

  15. Rob  ::  4:16 pm on July 23rd, 2012:

    … with the assumption that tax cuts are static.

  16. MITT'S OTHER TAX SECRET | Xtax  ::  2:33 am on July 24th, 2012:

    […] reductions by cutting tax expenditures,” Howard Gleckman, the editor of TaxVox, wrote in a blog post. “But it will be very, very […]

  17. Mitt Romney Won’t Release His Tax Returns: Wants The “Middle Class” To Pay Taxes For Him & His Cronies | 3CHICSPOLITICO  ::  8:22 pm on August 1st, 2012:

    […] TPC Tax Policy Center-7-10-2012 […]

  18. Desert Ridge real estate  ::  6:11 pm on September 25th, 2012:

    This is not only overly-simplistic; it strikes me as the wrong way (backwards) to look at the issue. In essence, it is being suggested here that the correct way to view the tax revenue raised by eliminating a deduction is to measure that against a contemporaeously implemented lower marginal tax rate rather than current law.

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