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A Bipartisan Way to Cap Deductions

By the Editors
December 03, 2012 6:30 PM EST
Illustration by Bloomberg View
Illustration by Bloomberg View

The big question in Washington should be how, not if, the U.S. can limit the individual income-tax breaks that cost more than $1 trillion in revenue each year.

Capping deductions is one of the few ideas both parties agree on. House Speaker John Boehner said this week that Republicans would consider proscribing tax breaks for some upper-income individuals. And President Barack Obama’s budget proposals for years have called for tax-deduction ceilings for the rich.

Over the decades, lawmakers have considered limits on popular deductions for mortgage interest, state and local taxes, and charitable giving, only to jettison the proposals out of concern that they would harm the housing market, millions of charities and much of the middle class. This time should be different.

Scaling back tax expenditures, which overwhelmingly benefit the wealthiest, will require sacrifice from many, but it can be achieved in ways that minimize unwanted consequences. What’s more, recent research shows that many of the effects lawmakers have long feared -- and that lobbyists have all too eagerly warned about -- are likely to be minimal.

The simplest approach is to cap all tax deductions at $50,000, allowing individuals to choose which breaks to claim, up to the limit. Setting a cap at $50,000 would primarily affect the richest Americans because most taxpayers’ deductions aren’t even close to that amount.

Charitable Credit

To blunt the potential for a steep decline in charitable giving, lawmakers could exempt such contributions from the cap and instead create a 25 percent refundable tax credit for households contributing at least $1,000. A couple donating $1,000 would get $250 back from the federal government -- even if they owed no income taxes. Under the current system, only those who itemize their taxes and have a tax liability can claim a deduction. And because the deduction is tied to marginal tax rates, the wealthiest get the biggest benefit.

According to the Congressional Budget Office, if such a credit had been in place in 2006, donations would have increased by $1.5 billion and the cost to the U.S. would have fallen by $2.4 billion.

A $50,000 limit would also largely mollify concerns that trimming deductions would harm the housing market and disproportionately hit taxpayers in high-tax states. First, it’s worth noting that about two-thirds of taxpayers take a standard tax deduction rather than itemizing, and therefore don’t benefit whatsoever from tax breaks. Of the roughly 33 percent of taxpayers who itemize, most claim far less than $50,000 in deductions. The average in 2011 for middle-income earners was $15,583, while those in the top 1 percent deducted about $173,670, according to the Tax Policy Center. Those figures include the charitable deduction, suggesting that a small fraction of taxpayers would hit the $50,000 ceiling.

As we have noted, there are good economic reasons to curtail the mortgage-interest deduction. It’s an inequitable subsidy that drives up home prices, encourages people to buy more house than they need or can afford, and rewards the rich. A top earner in the 35 percent tax bracket gets a $3,500 tax break for every $10,000 paid in mortgage interest, while a lower- earner gets just $1,500. In 2011, the average benefit for a middle-income earner was $139. For the top 1 percent, it was $3,752.

The deduction for state and local taxes is similarly unjust. It encourages states to raise taxes that provide public benefits for its residents yet the cost is shared by those who live outside the state. In other words, residents living in a low-tax state like Alabama subsidize public spending in a high- tax state like Connecticut.

Bigger Share

Several tax-reform panels, including commissions in 1985 and 2005, have called for abolishing the deduction. Although we wouldn’t go that far, a $50,000 cap would enable most itemizing taxpayers to deduct the same amount of state and local taxes they currently do, while still enjoying other deductions under the cap. High-income individuals, however, might be forced to pay a bigger share of their state and local tax bills -- not necessarily a bad thing.

How would all of this affect taxpayers? Those in the top 1 percent would see their average tax bill increase by about $51,548, for a 2 percent increase, according to the Tax Policy Center. Those in the middle income quintile (with earnings between $42,597 and $67,608) would see an average increase of $823.

Notably, it would help close the revenue gap. A $50,000 cap with a charitable exemption would raise about $490 billion over the next decade, according to the Tax Policy Center. Replacing the charitable deduction with the 25 percent credit would bring in an additional $25 billion over 10 years. Add those savings to the $566 billion gained by allowing the Bush tax cuts to expire on household earnings above $500,000 -- along with increasing the rates paid for capital gains and dividends to at least 20 percent -- and the U.S. gains about $1.2 trillion.

That’s pretty close to the $1.6 trillion Obama has called for. It is also a more realistic figure, given steep Republican resistance to raising taxes.

With its unsustainable fiscal situation made worse by the costly demands of the retiring postwar generation, the U.S. faces hard choices. Some Republicans, including Tennessee Senator Bob Corker, are already embracing the $50,000 cap as the least painful revenue-raising option. The U.S. has been on the cusp of enacting tax-expenditure reform before, only to walk away. This time, the nation’s dire financial straits demand action.

To contact the Bloomberg View editorial board: view@bloomberg.net.

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