Not All Curbs on Tax Preferences Are Created Equal
Because politicians seem unwilling to confront specific individual tax preferences, it is likely that any broad-based tax reform will be based on across-the-board curbs on deductions, credits, and exclusions. That’s how lawmakers could generate the revenue they need to reduce tax rates and (perhaps) help reduce the deficit without seeming to tackle popular tax subsidies such as those for mortgage interest or charitable giving.
But there are many different ways to broadly scale back tax expenditures. And while the distinctions among them may be easily lost in what is sure to be a complicated political debate, these methods yield very different outcomes. Some options would target the highest income households, others would raise taxes more broadly. Some would be fairly simple to administer, others would be mind-numbingly complex.
The lesson, you might say, is that a cap is not a limit is not a haircut.
To help sort out the differences, my Tax Policy Center colleagues Eric Toder, Joe Rosenberg, and Amanda Eng looked at six ways to reduce tax preferences across-the-board. To make sure they were comparing apples with apples, they designed each option so it would raise roughly the same amount of money (about $1 trillion over 10 years).
In addition, because supporters of these ideas have been pretty loose with their definition of what their global curbs would cover, Eric, Joe, and Amanda looked at each of the six in two ways: First, as if they targeted only itemized deductions; and second, as if they included those deductions plus two big exclusions—for employer sponsored health insurance and municipal bond interest. They also looked at whether the plans would retain or scrap the AMT and the current limit on deductions for high-income households (aka Pease).
The six plans they studied were:
- Limiting tax savings to a fixed percentage of adjusted gross income (AGI limit). Economists Marty Feldstein and Dan Feenberg of the National Bureau of Economic Research and Maya MacGuineas of the Committee for a Responsible Federal Budget floated a version of this idea in 2011.
- Placing a flat dollar amount on tax preferences (fixed dollar cap). This is similar to an idea raised by Republican presidential candidate Mitt Romney in 2012.
- Limiting the rate applied to exclusions and deductions (rate limit). President Obama has proposed limiting the tax savings from certain preferences to 28 percent, which affects those in higher tax brackets.
- Reducing all deductions and exemptions by a fixed percentage (haircut).
- Replacing all deductions and credits with a fixed rate refundable credit (refundable credit).
- Expanding the Alternative Minimum Tax to include additional preferences (broaden AMT).
How do they stack up?
Let’s start with distribution: On average, the options would raise taxes by 0.7 percent of pre-tax income. All are relatively progressive, but the effects of each on households at various incomes would be very different. Fixed dollar limits and a broader AMT would be most progressive while the haircut and AGI limit would be least progressive.
If simplicity is your goal, the picture would be very different. The haircut and refundable credits would be relatively easy to calculate. The rate limit would be much more complex and the AGI limit would be a nightmare.
What about incentive effects? To figure that, the paper looks at what would happen to a taxpayer’s decision to make a charitable gift under each option. All would reduce the marginal incentive to give, and the AGI limit and fixed dollar cap would cut it the most. However, the fixed dollar cap nearly eliminates any incentive for the top 1 percent to contribute while the refundable credit would increase the incentive for lower-income households to give to their favorite charity.
The plans Eric, Joe, and Amanda modeled are not the only possible options, of course. Global curbs could apply to more preferences, or fewer. They could generate more or less revenue. A legislative proposal would have to deal with the current AMT and Pease. Lawmakers would also have to choose whether to reduce the benefits of these preferences for only high-income households or for everyone.
Congress would have to answer a bucket-load of questions should it go this route and the debate won’t be easy to follow. But if this new paper is not quite GPS, it is a useful roadmap to check once pols start chattering about caps, limits, and haircuts.