In his first news conference since his re-election, President Barack Obama said, “I’m open to compromise and I’m open to new ideas” when it comes to solving the nation’s fiscal challenges.
That’s heartening news. When Obama sits down with congressional leaders for a fiscal chat this week, he should broker an agreement to limit the individual tax breaks that cost the U.S. Treasury more than $1 trillion every year.
Such a deal, which seemed unthinkable just a few months ago, now appears within reach as some Republicans signal a willingness to accept higher taxes as part of a deficit-reduction deal. “We cannot be, we must not be, the party that simply protects the rich so they get to keep their toys,” said Louisiana Governor Bobby Jindal.
The best ground for compromise appears to be scaling back so-called tax expenditures, the myriad deductions, exclusions and credits that allow individuals -- particularly the wealthiest Americans -- to lower their tax bills. Agreeing to cap the value of these deductions would be a significant step toward not only addressing crushing deficits but also averting the fiscal cliff, the $607 billion in tax increases and spending cuts scheduled to take effect in January. Democrats insist any plan to avoid the cliff include higher taxes on the rich, which could be achieved by limiting tax breaks. Without action, those fiscal changes threaten to plunge the U.S. back into recession.
Limiting tax breaks is only part of the deficit solution, of course, which must also include entitlement reform that controls spending on Social Security, Medicare and Medicaid. Tax changes that correct inequities, including eliminating favorable tax treatment for carried interest, capital gains and dividends, must also be in the mix.
Democrats have long insisted that any fix include higher tax rates on the top 2 percent of earners. The president reiterated at the news conference that he won’t extend the Bush tax cuts for the wealthiest. Yet he also said he’ll consider new ideas that allow the U.S. to raise revenue, maintain progressivity and ensure the middle class “isn’t getting hit.”
He should seize the opportunity within reach. Limiting tax expenditures would bring in new revenue, primarily from wealthier Americans, without raising tax rates. Setting a deduction cap at $25,000, for example, would generate about $1.3 trillion in new revenue over 10 years -- within spitting distance of the $1.6 trillion in new taxes Obama has called for.
A cap would also rein in distortive government subsidies that drive up home prices and health-care costs and misallocate capital. Research shows that the mortgage-interest deduction, for instance, encourages homeowners to borrow too much and buy bigger homes than they need, while siphoning capital that could be more productively deployed elsewhere.
Deductions could be limited in a variety of ways depending on how much revenue is desired and from whom. Obama has proposed limiting the benefit of tax expenditures for the top 2 percent of earners, which would raise about $288 billion over 10 years, according to the Tax Policy Center. An intriguing idea, floated by Republican nominee Mitt Romney during the presidential campaign, is to limit deductions to a certain dollar amount and allow individuals to pick which tax breaks they use. It’s a less progressive plan than Obama’s because it would raise taxes on more than the wealthiest, including those earning less than $200,000.
That would violate Obama’s campaign promise not to raise taxes on the middle class, but it’s a promise he’ll have to break sooner or later. A cap on deductions would still hit the rich the hardest, because the value of tax breaks increases with income. Households in the top income quintile received two-thirds of the benefits of tax expenditures in 2011, with average savings of more than $30,000. Those in the bottom three quintiles (with incomes under about $60,000) saved an average of less than $2,000, collectively about one-fifth of the total tax savings.
With a $25,000 cap, about 14 percent of the increased tax revenue would be derived from those earning less than $112,000 and roughly 19 percent would come from those with incomes between $112,000 and $228,000, according to Tax Policy Center estimates. Almost 52 percent of the increase would hit those in the top 1 percent. A taxpayer earning between $100,000 and $200,000 would see an average increase of about $2,491; someone earning $1 million or more would see an almost $14,000 increase.
House Speaker John Boehner is sure to come under intense pressure from anti-tax crusaders. But Obama could hasten a deal by dropping his insistence that the Bush tax cuts expire for the top two tax brackets. That’s anathema to Democrats -- Treasury Secretary Timothy Geithner this week reiterated Obama’s opposition to such a move -- yet it’s the only way Republicans might accept a deal. And if the aim is to get the rich to pay a little bit more -- as they should -- closing loopholes will achieve that.
One way is to push forward with Obama’s proposal to tax dividends, capital gains and carried interest, a form of income that accrues to hedge fund and private equity managers, at higher rates. That would boost the government’s coffers by an additional $242 billion over 10 years, according to U.S. Treasury estimates. Obama should insist on that change as part of a deal to maintain the Bush tax rates on top earners.
Washington no longer has the luxury of delay. It must strike a deal quickly to avert looming spending cuts and tax increases and to set a path for long-term deficit reduction. Raising taxes and cutting spending will hurt. But the fact that Republicans and Democrats are now coalescing around a similar idea to raise revenue by scaling back tax expenditures is no small feat. Obama should seize this moment to strike a deal and show voters he got their message: Compromise is king.
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