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Pepperdine University School of Law

Friday, February 22, 2013

Feldstein: A Simple Route to Major Deficit Reduction: Capping Deductions at 2% of AGI

Wall Street Journal op-ed:  A Simple Route to Major Deficit Reduction, by Martin Feldstein (Harvard University, Department of Economics):

Putting a cap on tax expenditures—those features of the tax code that are a substitute for direct government spending—can break the current fiscal impasse and prevent the dangerous explosion of the national debt. If a cap is combined with entitlement reforms, the government will also be able to reduce tax rates and increase some spending to accelerate the economic recovery. ...

Limiting the tax savings from all deductions and the two major tax exclusions to 2% of an individual's adjusted gross income would reduce the deficit in 2013 by $220 billion. This 2% cap does not refer to the amounts of the deductions and exclusions but to the tax saving. This means that for someone taxed at a 25% marginal tax rate, the 2% cap would limit deductions and exclusions to 8% of that individual's adjusted gross income.

The 2% cap could also be modified to retain the existing deduction for all charitable contributions and to allow employees to exclude the first $8,000 of employer-paid health-insurance premiums from the cap. This would still reduce the current year's deficit by $141 billion. That translates to about a $2.1 trillion reduction in the national debt over the next decade.

Higher tax rates, in short, are not necessary in order to raise substantial revenue. Indeed, some of the $2.1 trillion could be used to reduce current tax rates and promote growth.

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This particular proposal does not simplify the tax code. The description and example makes it sound like a second AMT calculation.

Posted by: yup_hes_an_economist | Feb 22, 2013 6:22:49 AM

Feldstein's solution exempts all tax subsidies that enter into the computation of AGI -- for example, expensing or accelerated depreciation rules. It also exempts tax subsidies for corporations. Not clear why these exemptions are warranted.

Posted by: Theodore Seto | Feb 22, 2013 11:28:07 AM

Just what the tax code needs: another back door tax increase.

If a deduction can be justified as an adjustment to taxable income, it should be allowed, period. If a tax credit can be justified as a subsidy for a certain activity, it should be allowed, period. If the current provisions do not constitute fair treatment, Congress should remove them entirely.

Fairness provisions should not be turned on and off based on income or any other consideration. It is by definition unfair to taking away a benefit which was originally included as a matter of fairness.

Out tax code should be principled, not sneaky and inscrutable. Congress would never tolerate from taxpayers the kind of devious behavior it engages in itself when it writes tax law. It's disgusting. If revenue is needed, Congress should get it fairly and honestly. For once.

Posted by: AMTbuff | Feb 22, 2013 6:19:15 PM

Another fairness issue here is retirement planning. Government workers and others with defined benefit plans automatically defer taxes on a large portion of their earned income until retirement. Accumulated present value of a pension can run into the millions of dollars, untaxed until it is paid out. Where is the fairness in denying the same income tax deferral to workers who only have defined contribution plans?

A cap on tax benefits would put defined contribution workers participants at a severe tax disadvantage relative to defined benefit workers. That's just not fair.

Add to that the fact that taxes from the defined contribution public are funding the salaries of the privileged class of defined benefit government employees and the result will be some very upset voters.

The only fair way to end deferral would be to assess income tax on each year's increase in present value of defined benefit pensions. Such an up-front tax might give unions second thoughts about the wisdom of pressing for absurdly generous defined benefit plans. The resulting disincentive for high public employee pensions would be some consolation to defined contribution taxpayers who lose their deferral.

Posted by: AMTbuff | Feb 24, 2013 11:49:08 AM

AMTbuff, you seem to be really worried about defined benefit plans. These plans are relics of the past. No new ones are being created. Almost 30 years ago the federal government ended the generous, defined-benefit CSRS, shifting instead to the three-part FERS, with a much smaller, partial defined-benefit segment. Many state governments, such as Maryland, followed suite. Moreover, the government plans do not accumulate present values running into the "millions of dollars." Back in the mid-1980s, present values of some government plans were in excess of $1mm. But with today's exceptionally low rates of return on investment, there are no more million dollar present values. Most civil servants will have difficulty maintaining a comparable standard of living on the "new" three-part plans (small annuity/social security benefits/401(k) distributions).

Posted by: Publius Novus | Feb 26, 2013 6:26:30 AM

Police, fire, and prison employees (all of them, not just the guards) in California routinely exceed $1M in present value of benefits. Payouts exceeding $100k per year are common, with inflation adjustment, starting at age 50 to 55.

Today's low interest rate INCREASE the present value of these defined benefit streams even if they persuade governments to be less generous to new employees.

Two-tier benefit programs are just beginning to take hold, but the new government employees are not going to pay for all the old benefits. The market doesn't work that way. Taxpayers are on the hook for promised benefits until the state or local government goes bankrupt. (In a crisis I do expect Congress to legislate a bankruptcy option for states unless hyperinflation makes it moot.)

The fairness issue is the same regardless of the amounts. If pension payouts are to be taxed as they are earned rather than as they are paid out, then defined benefit pensions need to be fully included in that change.

Posted by: AMTbuff | Feb 26, 2013 10:43:05 AM