The Real Lesson About Capping Itemized Deductions

By :: October 18th, 2012

The Tax Policy Center is back in the political cauldron, this time in the wake of its new research that looks at the revenue and distributional effects of caps on itemized deductions.

TPC’s aim was to analyze an interesting idea that could find its way into future tax reform plans. Its conclusion was a mix of good and bad news. The good: Such a cap is a highly progressive way to raise substantial revenues. The bad: Even eliminating all itemized deductions cannot raise enough money to pay for a tax reform that significantly cuts rates without adding to the budget deficit.  

But, alas, we are in the midst of a contentious political season. And because Mitt Romney has at least three times in the past few weeks raised the possibility of such a deduction cap, his campaign has gotten defensive about TPC’s results, accusing the center of, among other things, being “misleading and deceitful.”

This is, to say the least, odd, since TPC’s findings provide evidence that a deduction cap is a pretty good, though insufficient, idea.   

Let’s all take a deep breath here. TPC did not try to analyze Romney’s plan (since he won’t tell anybody what it is, we can hardly model it). Rather, our analysis applies far more broadly to any tax reform. And the real message is this: Doing reform that significantly reduces rates without adding to the budget deficit requires lawmakers to curb more than itemized deductions. If you want to substantially reduce rates, going after popular tax breaks such as deductions for mortgage interest, charitable gifts, and state and local taxes, is only the beginning.

Reformers also have to look at other tax preferences that are ingrained in economic behavior, such as the exclusions for employer-sponsored health insurance and municipal bond interest, tax subsidies for retirement savings, and the low rates on capital gains and dividends.

This is hardly an earth-shattering insight. After all, it is what the chairs of President Obama’s fiscal commission, Erskine Bowles and Alan Simpson, did in 2010. It is also what the Bipartisan Policy Center’s fiscal tax force, chaired by former GOP senator Pete Domenici and former Clinton budget director Alice Rivlin, concluded two years ago. TPC has been telling the same story through a series of research papers since last summer.

Here’s where things get complicated for reformers. A cap on deductions has three big advantages. It is a very progressive way to raise new revenues. It is administratively relatively simple (through not without its problems). And it is politically attractive since it avoids having to tackle individual tax preferences—each with its own powerful constituency—one at a time.

But if the deduction limit doesn’t raise enough money, lawmakers would have to reach into other tax preferences to pay for big rate reductions. And many of them, such as the exclusion for employer-sponsored health insurance and tax incentives for retirement savings, disproportionately benefit the middle-class.

Curbing them would make it much harder to maintain progressivity than just capping deductions does. A cap on exclusions is lots more complicated. In addition, curbing middle-class savings incentives at least may not be the smartest long-term economic policy.  

That brings us to tax preferences for capital gains. Raising the rate on gains could generate substantial revenue in a very progressive way. Indeed, both Bowles-Simpson and Rivlin-Domenici chose to tax gains at ordinary income rates (though those rates were substantially lower than today rates).

And that, in the end, may be the real story here. Lawmakers may find that the road to substantially cutting rates without adding to the deficit may inevitably lead through the capital gains tax. If they don’t want to mess with capital gains, they may have no choice but to scale back their ambitions when it comes to rate reductions. And that applies whether you are Mitt Romney or anybody else.    

 

8Comments

  1. Brian  ::  3:19 pm on October 18th, 2012:

    Raising the capital gains tax is the way to go, but you must first have corporate tax reform to alleviate the double taxation and the distortion effects. Not taxing dividends at the corporate level and lowering the corporate tax rate will certainly help.

  2. Michael Bindner  ::  3:57 pm on October 18th, 2012:

    I find nothing to support the contention that Mitt Romney won’t eventually agree to taxing capital gains and dividends at normal income rates – especially when the normal income rate is 28%. Romney won’t say that, however, because it would tick off his base (both the wealthy donors and Tea Partiers who carry their water).

  3. Kevin  ::  4:02 pm on October 18th, 2012:

    I think the Romney camp understands they will have to ultimately give less than a 20% rate cut. All the analysis I’ve read seems to suggests this number is set in stone, yet everything on the revenue increase side of the leger is fungible, I don’t get that? In my experience, politicians always ask for at least twice of what they want in any type of budget deal as a starting place for the negotiations that will have to be made with the other side. Obama did this in 2009, the initial cost of ARRA was well in excess of what was actually passed. So, suppose Romney really wants a 10% cut. Start off promising 20%, which sounds better on the campaign stump. Then when you begin negotiating with the Democrats next year, you’ll have 10% to offer them as a bargain. The 17.5k or 25k itemized cap would come a lot closer to paying for a 10% rate cut than a 20% and be a good first step towards.

  4. AMTbuff  ::  4:19 pm on October 18th, 2012:

    I thought Romney always favored taxing employer-paid health care. Regardless, that should be the very first base broadener for any plan. Second, Bowles-Simpson converted the mortgage deduction to a 15% credit. That technique should be included in TPC’s analysis if it wants to claim that “our analysis applies far more broadly to any tax reform”.

    Third, it’s disconsonant that groups and individuals who normally favor tax reform are lining up to poke holes in a nascent plan. All these experts are fully aware that tax reform will surely fail unless the details are negotiated by Congress in secret and presented as a take it or leave it package, as in 1986. The final package is often quite a distance from the original outline, so criticizing the outline as incomplete is pointless.

    Are these experts non-partisan or partisan? If Obama had offered a similar outline of a plan, would these same experts have rushed to discredit it? Or would they have instead looked for adjustments which would make the plan work?

    There are many possible adjustments that are conceptually consistent with Romney’s statements: tax credits in place of all deductions, taxing health care benefits including flexible spending accounts, and capping the total tax credit. TPC’s analysts could come up with 5 mathematically feasible versions every day if they wanted to. But they don’t want to.

    Gene Steuerle had enough common sense to stay out of this hot mess. Kudos to him. Was Len Burman the last of the adult supervision at TPC? I used to think you guys and gals were the greatest thing since sliced bread. TPC has severely damaged its non-partisan image this year. For what benefit?

    Incidentally I still believe that tax reform will not gain sufficient political support until we reach a Greece-style borrowing crisis. That’s why it’s doubly sad to see the TPC exert so much effort to kill an outline for tax reform “lite” pre-crisis. I would personally lose a bundle in any tax reform worthy of the name, but the country would win. So I support it. TPC should too.

  5. Vivian Darkbloom  ::  5:16 am on October 19th, 2012:

    “But, alas, we are in the midst of a contentious political season. And because Mitt Romney has at least three times in the past few weeks raised the possibility of such a deduction cap, his campaign has gotten defensive about TPC’s results, accusing the center of, among other things, being “misleading and deceitful…Let’s all take a deep breath here.”

    That’s right, but this applies equally to the TPC. The TPC has been extraordinarily defensive about legitimate criticism of its “analysis” of the Romney “plan”. That defensiveness has caused it to become extremely non-objective in its responses to that legitimate criticism. Here, and earlier, we’re told that that criticism is merely “partisan” and/or “vitriolic”. Sorry, but that’s a self-serving copout.

    Also, despite its repeated (and very unrealistic) demand that the Romney campaign release “additional details” of his tax “plan”, the TPC continues to stonewall requests to release more of its details. I suggest the latter is due to the fact that the TPC, in full defensive mode, does not want to give its critics the ability to look behind those numbers for fear that they might be subject to even more challenge. The TPC focus now is on a full-bore, one-sided defense of the original “analysis”, which seems to bear more on defending personal reputations than anything—this is hardly a position that encourages objectivity and non-partisanship. The same defensiveness is likely true of Romney, but then again Romney is running for President in a political campaign charged with rhetoric. As far as I know, the TPC, a not-for-profit, taxpayer subsidized, “non-partisan” group. Gene Steuerle, of the Urban Institute of all places, correctly and wisely pointed out that it is unrealistic for political candidates to reveal the kind of details that would allow for the sort of revenue estimate (yes, even if there were more details, this would be an *estimate*) that would allow for valid “scoring”. And yet, the TPC repeatedly slams Romney for not doing so. Surely, the TPC must know that it has put Romney in an untenable corner—-either release more details of your plan and commit political suicide or suffer the results of our damning “analysis” based on our own assumptions and estimates. In the meantime, Romney’s opposition has gleefully seized upon the incomplete and inaccurate descriptions of that analysis for great political benefit in numerous campaign ads, friendly partisan media and in presidential and vice presidential debates. In contrast, the TPC has had little, if anything to say about Obama’s “plan” (or the lack of it). Is this partisanship? I guess only those involved would know what their motivations are.

    Howard seems to object to characterizations of the TPC’s various attacks on Romney as “misleading and deceitful”. I happen to think those characterizations are appropriate. Here’s some of the reasons why.

    First, the original TPC study incredibly claimed that it was not making any assumptions about the Romney plan. They then proceeded to make a very large number of assumptions many of which were not (as the TPC claimed) either reasonable or favorable to Romney’s “numbers”. I have had private correspondence with Bill Gale over the issue of the effect of the estate tax elimination and the “step-up” in basis. The TPC assumed the step-up in basis would be continued under Romney’s proposal. When confronted with arguments to the contrary, my arguments were called “compelling” and it was conceded that this item would have an effect on TPC’s numbers (in Romney’s favor). While Gale has given me this information privately, he’s yet to make it public. I call it “misleading and deceitful” to keep silent on this issue. What’s the excuse for keeping this type of information from the public? It’s not for me to inform the public about it—this is a matter for the TPC and Gale to be more forthcoming about. It might perhaps be considered indiscrete to deal with the matter in this way, but perhaps Mr. Gale and others at the TPC need to know what it feels like to be challenged on releasing more details. I can’t imagine why there would be any hesitation to do so–again, neither the TPC nor its members are running for political office (as far as I know).

    When faced with criticism of its work, Gale and other TPC members have characterized the issue as “one of simple math”. This either reinforced or inspired a key Democratic talking point. But, nothing could be further from the truth. A revenue analysis is never “simple math”. These analyses, and particularly this one, are based on many, many assumptions and estimates which are inherently subject to large margins of error and over which reasonable people can and do differ. And now, Howard writes this:

    “TPC did not try to analyze Romney’s plan (since he won’t tell anybody what it is, we can hardly model it). Rather, our analysis applies far more broadly to any tax reform.”

    Well, now I’m confused: If the TPC did not “try to analyze Romney’s plan” how on earth can the TPC continue to claim that this is a “matter of simple math” and that “Romney’s math does not add up”? Or, as Bill Gale colorfully and hyperbolically put it to the New York TImes:

    “The combination of stuff they’ve specified is not only impossible — it is impossible several times over,” said William G. Gale, the director of economic studies for the center-left Brookings Institution and a co-author of a definitive Tax Policy Center study on Mr. Romney’s plan, whose arithmetic the Obama campaign is citing.”

    To initiate and reinforce the idea that this is “simple math” and that “Romney’s math does not add up” is both misleading and deceitful even though Gale would likely base his defense on the “stuff they’ve specified qualification” which no one reading a general circulation paper is going to think twice about. (And, for the NYT to call any revenue projection “definitive” is equally misleading and deceitful). And to claim that the TPC analyzed Romney’s plan and now to now claim here that they didn’t, is both misleading and deceitful. And, this kind of hair splitting is one that is having huge consequences in a closely contested presidential campaign.

    This particular response to the “itemized deduction” analysis is also “misleading and deceitful”. As AMT points out below, Romney certainly has not restricted his plan to raise additional revenue to “itemized deductions”. There are many adjustments to income and exclusions to income that would likely be affected that are not “itemized”. The TPC is strongly suggesting here that the revenue raised would be limited to itemized deductions. That is both misleading and deceitful.

    Also, the latest TPC missives on the revenue raising potential of eliminating or restricting itemized deductions compares this potential revenue gain with a $5 trillion tax “cut” and strongly suggests any estimated difference would be the shortfall in Romney’s plan. In addition to the fact that itemized deductions are not the only thing “on the table, as the TPC well knows, the $5 trillion number (based on extrapolation of its own *estimate* and increased by $500 billion for assumed GDP growth) does not only include individual income tax “cuts”. It also includes $1 trillion in corporate tax cuts, the cost of which Romney suggests would be offset by eliminating corporate tax deductions, credits, etc. To compare $56 trillion with only itemized deductions is certainly “misleading”, if not also “deceitful”.

    One could go on, but another main point of disagreement between the TPC and others who have studied the issue is over the macro economic benefits of combining marginal rate cuts with eliminating deductions to pay for them. The TPC assumes none (even though it assumes negative micro effects) but fails to mention here that this could potentially be a major source of “revenue” to pay for those “cuts”. Failure to do so, even though one might reasonable disagree, is quite arguably both “misleading” and “deceitful”.

    There is one thing the TPC is certainly right about: Tax reform is hard—and so is reducing tax rates and eliminating deductions to pay for them. But, “hard” is not “impossible”. To claim that this is a matter of “simple math” and that Romney’s “math does not add up” is misleading and deceitful. And, that approach by the TPC makes the process even harder than it would otherwise be.

  6. Tax Roundup, 10/19/2012: How big can small be? Plus: gift tax annual limit goes to $14,000 in 2013. « Roth & Company, P.C  ::  9:36 am on October 19th, 2012:

    […] Gleckman,   The Real Lesson About Capping Itemized Deductions  […]

  7. WSJ: Romney’s Tax Deduction Cap: Good Economics, Better Politics - 美国税1on1  ::  8:58 am on October 20th, 2012:

    […] Tax Vox Blog, The Real Lesson About Capping Itemized Deductions […]

  8. Mike  ::  12:33 pm on January 14th, 2013:

    Converting all deductions to credits at 15% would be a good approach to reducing tax expenditures and ensuring that $1000 deducted from a millionaire’s tax return didn’t produce significantly more economic benefit than $1000 deducted from his gardener’s return. The present system makes the value of the deduction $350 for the person paying at the top rate, vs. 10% for the person who may only pay taxes at the bottom rate.

    Then capping the total amount of credits would as you say avoid the fight between the various interests who champion the various deductions.

    That said, the delta between taxes raised and dollars spent is so great than some rate adjustments will have to be made. Republicans have to budge on that, even more than they did for the cliff deal, but the President and his party should do their part by giving on spending. We have both a tax and a spending problem resulting in a future-damaging deficit problem. This is undeniable, so let’s get working.