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Feldstein on an Itemized-Deductions Cap



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Martin Feldstein, a professor of economics at Harvard and the former head of Reagan’s Council of Economic Advisers, has an op-ed today in the Washington Post presenting the case for a cap on the amount of itemized tax deductions as a percentage of one’s income, something he’s done elsewhere on a number of occasions, and formally set out in 2011. He writes:

President Obama’s recent meetings with members of Congress have raised hopes that a major fiscal deal will replace the “sequester” and put the federal debt on a healthier long-term path. But the key barrier to such a deal remains the disagreement between Republicans and Democrats about the balance between raising revenue and cutting government spending. Republicans say they are against any further increase in taxes. Democrats, including the president, say that any budget deal must include additional revenue as well as spending cuts.

Fortunately, Democrats indicate that they want to raise the extra revenue without increasing tax rates. Raising revenue without increasing tax rates requires eliminating or reducing the subsidies in the U.S. tax code. Such subsidies, for things as varied as hybrid cars and increased health insurance, are really the government spending through the tax code. That is why they are officially referred to as “tax expenditures.”

Reducing those subsidies, then, is really cutting government spending. The resulting deficit reductions show up on the revenue side of the budget, but the economic effect is to cut government spending.

Billions of dollars of revenue are lost through many relatively small subsidies, such as the tax break given to homeowners who install better insulation or buy a more efficient refrigerator. These may be desirable actions, but given the current budget situation, the country cannot afford to subsidize them. Anyone opposed to government spending should favor removing these subsidies from the tax code.

Feldstein proposes a cap of itemized deductions at 2 percent of one’s adjusted gross income, while exempting the charitable deduction. He explains that it’s politically difficult to eliminate specific deductions, which is why something like a broad cap is probably the right way to go about it. Feldstein’s proposal is a seriously draconian cap, though — by his calculations, it would raise $2.1 trillion over the next ten years, some of which revenue he’d use to cut tax rates. That’s one realistic model for the kind of tax reform proposed in the House Republican budget, which hopes to end up with 10 percent and 25 percent tax brackets, requiring a huge amount of offsetting revenue to be raised from eliminating loopholes. But I think there’s a good case to be made that individual marginal tax rates in the U.S. don’t really need to be much lower, so such cuts aren’t worth a dramatic reduction in itemized deductions, but a modest version of his plan might still be useful.

A more generous cap could either raise some revenue to offset particularly undesirable sequester cuts, pay for a significantly expanded child tax credit, or be offered as a sweetener to Democrats in exchange for entitlement reforms. Feldstein’s plan also would raise taxes on as much as 80 percent of households, while a looser cap would apply to much fewer households — that would make it more politically feasible and mean that it falls only on individuals who benefit greatly from such tax subsidies.

He chooses to exempt the charitable deduction, which is sensible; encouraging private philanthropy should be especially important to conservatives who believe in a strong civil society, especially one that’s increasingly being co-opted or marginalized by government. Retaining the charitable exemption significantly reduces the amount of revenue a cap raises, and that did present a problem when Republicans were trying to offer up an alternative to the revenue the president was proposing to raise in his solution to the fiscal cliff (which would have gotten partway to his long-term budget goal of about $1.5 trillion in new revenue over the next ten years). That’s much less of a problem now because the fiscal-cliff deal added about $600 billion in new revenue to the baseline, leaving less of a need from all parties for deficit reduction, especially on the tax side. So if a Republican or centrist revenue proposal were to come forward — whether to pay for restoring defense spending, rate cuts, or a more family-friendly tax policy — it could be much more modest, paying mostly for the benefits wanted rather than serving as a vehicle for deficit reduction.

Feldstein argues in his piece that those pushing for limiting deductions or closing loopholes to raise more revenue can and should make the case that it’s actually a form of cutting government spending, saying that “Republicans should recognize that limits on tax subsidies are reductions in government spending.” There’s a real case for this, best laid out to my knowledge by Donald Marron in a 2011 National Affairs essay — but it’s a complicated one and doesn’t seem likely to be a clear political winner. Further, its theoretical best audience, people who most strongly oppose government spending, surely are more sympathetic to, say, Grover Norquist and Americans for Tax Reform’s total contempt for this argument and belief that closing loopholes is a bona fide tax increase.

#more#A much more widely appealing political case (to left and right) would seem to be an anti-cronyism strategy, pointing out the ways in which tax exemptions, when they’re not limited in some way, subsidize special interests — the mortgage-interest deduction inflates housing prices and is prized by the real-estate and construction industries; the state-and-local deduction subsidizes high-tax, high-spending municipalities and especially the wealthiest people who live there; the step-up basis of capital gains is a huge gift to the few who confer large inheritances, etc. Of course there are good reasons for these exemptions, too, some of which I agree with, but the arguments against them can be quite politically attractive. People are a lot more likely to be convinced that these are unfair advantages given to constituencies that they don’t like than they are to believe that the programs are literally government spending. (Obviously, both strategies have already been tried, neither to much success.)

I hadn’t thought of this but actually, as Reihan points out over at the Agenda, something like Feldstein’s proposal may be more relevant, especially in its aggressive form, to Senate Democrats. They’ve just put forth a budget that intends to raise $975 billion in taxes over the next ten years and say that it should be done by cutting loopholes and deductions for wealthy Americans (they leave the specifics to the Senate Finance Committee). Feldstein’s approach is not as progressive as they’d like, and they might have to resort to something like the proposal Mitt Romney floated in the campaign, a cap on itemized deductions at something like $25,000 per filer. Feldstein lays out another one of the expenditure-limiting options, which President Obama has proposed — reducing the value of each dollar of deductions for high-income earners, so, say, a maximum value of 28 percent rather than 39.6 percent those earning over $400,000 would normally get. Feldstein points out that the president’s proposal doesn’t raise nearly as much as his own plan, nor does it raise anywhere near as much as the Senate will need, but it’s possible it could be made more aggressive.

Regardless, if Democratic senators put forth a revenue plan that relies on limiting deductions, interestingly, they will finally have to abandon the charade that loopholes exclusively carved out for the wealthy amount to an actually significant amount of revenue. In order to raise the revenue they want, they will have to limit deductions overall or remove extremely popular, broad-based ones, implicitly admitting that the important tax expenditures are ones many ordinary Americans use, too. They can still do that in a pretty progressive way, but in doing so it’ll be made obvious that wealthy Americans do reduce their tax burdens significantly — but with relatively quotidian itemized deductions that are only worth a great amount to the 1 percent because they pay so much in taxes in the first place.



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