Greg Ip on the Obamney Tax Plan

by Reihan Salam

Greg Ip of The Economist has written a post on how Democrats and Republicans might work together to fix the tax code, if only temporarily. Rather than raise revenue by raising tax rates, one can imagine a settlement between President Obama and congressional Republicans that freezes current rates in place while curbing tax expenditures in a progressive manner:

So the price for Democrats is that tax reform must be progressive: after-tax incomes of people at the top must be squeezed more than for people at the middle. Thus far, Mr Obama has equated that with allowing the top two income tax brackets to return to their pre-2001 levels. But there is an alternative route to the same goal that does not require higher rates, and it comes courtesy of Mitt Romney. Recall that when asked how he would pay for a 20% cut to marginal rates, he proposed a cap on deductions, an idea proposed in 2011 by Martin Feldstein, Maya MacGuineas and Daniel Feenberg.

I don’t have a ready estimate of how much capping deductions for those earning more than $250,000 would raise. But you can ballpark it by looking the Tax Policy Center’s estimatesfor capping itemized deductions at $50,000. It would raise $749 billion over 10 years, within the $800 billion that Mr Boehner has previously agreed to. That’s also more than the $429 billion yielded from returning the two top rates to their pre 2001 levels. The appeal for Republicans is that no one’s rates go up, and the preferential rate for capital gains and dividends is preserved. The appeal for Mr Obama is that it is highly progressive. According to the TPC, less than 1% of the bottom 60% of households would pay more tax while the top 1% would  pay 79% of the additional revenue. The average tax rate for the bottom 60% wouldn’t change, while it would go up 2 percentage points for the top 1%. It’s worth noting that Mr Obama’s budgets proposed capping the value of deductions for upper income households at 28%, which would have raised $584 billion over 10 years. Prior to 2001, the personal exemption and itemized deductions phased out for upper income taxpayers; those phaseouts were eliminated by the Bush tax cuts. Mr Obama’s budget would reinstate them, raising $164 billion over a decade. (These provisions would raise considerably less revenue if the two top rates did not go up.)

Would such a deal fly? One source close to House Republicans tells me: “I think they’d take it; they’re holding no cards at the moment… The capping of deductions would be very magnaminous and a good way to lay the groundwork for negotiating real tax reform.” But, he adds, “I don’t think Obama would offer that—why not fall back to Reid-Pelosi and increase it on people making over $1 million and dare house Republicans to walk away from that? Sacrificing the chance to earn political points will be very difficult for Democrats to do.” [Emphasis added]

I have heard something similar from my sources as well — that President Obama may well press for extension plus a millionaires’ tax bracket, an approach that would have populist appeal and that might peel off a handful of Republican senators.

That said, it is worth thinking through what a fallback plan might look like. My preference, like that of Ramesh Ponnuru, Yuval Levin, and others, is that the GOP should campaign on a family-friendly tax reform modeled on Robert Stein’s proposal that would freeze the top income tax rate. Assuming the president wouldn’t go for it, as is very likely, the Feldstein-MacGuineas-Feenberg cap is a solid idea, only it will attract intense resistance from non-profit organizations. We might wind up with a deduction cap that preserves a carve-out for charitable contributions.

Another alternative is a modified version of a 2006 plan from Lily Batchelder, Fred Goldberg, and Peter Orszag:

Policymakers have created tax incentives for homeownership, retirement saving, education, and medical expenses. Other tax incentives seek to promote work, charitable giving, and investment in lifeinsurance, annuities, and state and local bonds. Together, these tax incentives reduce federal tax revenues by about $500 billion a year, or roughly 4 percent of Gross Domestic Product. Structuring these tax incentives most efficiently is therefore an immensely important policy matter.

Approximately $420 billion of these existing tax incentives operate through deductions, exemptions, or exclusions.Such tax incentives tie the size of the taxbreak to an individual’s marginal tax bracket: A deduction of $1, for example, is worth 35 cents to someone in the 35 percent marginal bracket but only 15 cents to someone in the 15 percent marginal bracket. Such incentives thus provide relatively weak incentives to those in low tax rate brackets. Furthermore, these types of tax incentives fail to reach the increasingly significant share of low and moderate-income individuals and families who do not have any federal income tax liability to offset in any given year. More than 35 percent of households during any given year have no income tax liability; these households are home to almost half of all American children.

Refundable tax credits represent adifferent approach. Since they are a credit, rather than a deduction or exclusion, they do not depend on a household’s marginal tax bracket. A tax credit of $1, for example, reduces taxes by $1 and thus is worth the same to households in the 35 percent bracket or the 15 percent bracket. And since they are refundable, they provide benefits to all tax filers, regardless of whether they owe income taxes on net.

This would certainly make for a more progressive tax code while keeping current rates in place, and the size of the uniform tax credits would depend on the revenue target. 

The Agenda

NRO’s domestic-policy blog, by Reihan Salam.