Diametrically opposed as the tax plans of President Barack Obama and Republican nominee Mitt Romney may be, one area of agreement is emerging: The government needs to limit the countless deductions, exclusions, exemptions and credits that cost the U.S. more than $1 trillion in revenue every year.
Although their motivations differ radically, their shared desire to tackle such tax expenditures is an encouraging sign at a time of waning confidence in Washington’s ability to handle the immense fiscal challenges facing the country. Federal spending now accounts for about 23 percent of economic output, while taxes account for about 15 percent -- an imbalance that won’t correct itself. Absent serious fiscal restraint that addresses unaffordable tax cuts and spending, the federal debt is expected to grow by as much as $11 trillion over the next decade.
Closing the gap will require tough decisions and shared sacrifice. Targeting tax expenditures can help by opening a lucrative source of revenue. It can also make the tax code more progressive, because many breaks provide a bigger benefit to wealthier taxpayers. That’s one reason this solution has been embraced by several bipartisan deficit reduction panels, including the Simpson-Bowles fiscal commission and the group headed by former Clinton budget director Alice Rivlin and former Republican Senator Pete Domenici.
Romney’s idea is to cap individual deductions and credits for all taxpayers at a certain dollar amount -- he’s tossed around $17,000, $25,000 and $50,000 -- and allow people to choose which ones to take. “Your home mortgage interest deduction, charity, child tax credit and so forth, you can use those as part of filling that bucket,” Romney said in his second debate with Obama this month. The nonpartisan Tax Policy Center says at those three levels, Romney’s plan would increase revenue by $1.7 trillion, $1.3 trillion and $760 billion, respectively, over 10 years.
Obama’s plan, laid out in several White House budgets, would affect only the wealthiest taxpayers. He would limit the benefit of deductions for people in the higher tax brackets (such as his proposed top brackets of 36 percent and 39.6 percent) by treating those taxpayers as if they were in the 28 percent bracket. A top earner who paid $10,000 in mortgage interest, for example, would reduce his tax bill by $2,800 rather than the $3,960 that would otherwise be allowed. The plan would increase revenue by $288 billion over the next decade, according to the Tax Policy Center.
Both ideas are good starting points for addressing what are essentially distortive government subsidies. Economic research shows the two biggest tax expenditures -- the mortgage interest deduction and the employer-provided health-care exclusion -- drive up home prices and health-care costs. Homeowners borrow too much and buy bigger homes than they need. Employees choose unnecessarily expensive health-care plans and use medical services that aren’t cost effective.
Any effort to curb deductions will inevitably hit the wealthiest Americans, who benefit most from the breaks. More than 80 percent of the tax savings from itemized deductions go to those in the top income quintile, and more than one-fourth accrue to the top 1 percent. (Higher-income individuals are more likely to itemize their taxes, and they get a bigger benefit because they’re in higher tax brackets.)
All three of Romney’s proposed caps would increase taxes on the top 1 percent, with an average increase of about $51,000, according to the Tax Policy Center. Middle-income taxpayers would also see an increase ranging from about $707 (under the $50,000 cap) to $886 (with the $17,000 cap). The tax bite could be larger for those in the middle if Romney includes employer-provided health care (though it is technically an exclusion, not a deduction) in his cap. His running mate, Paul Ryan, has indicated he would target the health exclusion.
One big flaw in Romney’s proposals is that they wouldn’t increase federal revenue. That’s because he says he would use the money saved to help pay for a 20 percent across-the-board cut in tax rates. His campaign has also challenged the Tax Policy Center’s analysis and suggested that no one would see a tax increase, leaving the electorate to guess how the whole plan would actually work.
Obama’s proposal would direct the excess revenue toward deficit reduction. But while the wealthiest Americans can afford to see their taxes increase, tax expenditures need to be curtailed more broadly if the U.S. is to make a significant dent in the deficit. Obama has ill-advisedly promised not to raise taxes on any individual earning less than $200,000, making it hard for him to raise the revenue needed.
Still, there’s reason for some optimism. Both candidates clearly understand the need to get tax expenditures under control. Rather than eliminate individual deductions, both are wisely seeking to limit the benefit taxpayers can claim. Democrats and Republicans in Congress should build on this consensus to get the U.S. on sounder financial footing, regardless of who wins in November.
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