Paul L. Caron

Thursday, May 5, 2011

Feldstein: Capping Individual Tax Expenditure Benefits

New York Times op-ed, Raise Taxes, but Not Tax Rates, by Martin Feldstein (Harvard University, Department of Economics):

Reducing the budget deficit and stopping the explosion of our national debt will require more tax revenue as well as reduced government spending. But the need for more revenue needn’t mean higher tax rates. As the bipartisan fiscal commission appointed by President Obama stressed last year, tax revenues can be increased substantially by limiting the deductions, credits and exclusions that are essentially government spending by another name. ... At their worst, such tax expenditures create incentives for wasteful borrowing and spending; they have been factors in the mortgage crisis and the rising cost of health care. ...

Despite the strong case for limiting tax expenditures, it is politically difficult to do so because no one wants to give up benefits. So here is a way to curb this loss of revenue without eliminating any individual deduction: limit the total tax saving for any individual to a maximum percentage of his total income. Daniel Feenberg of the National Bureau of Economic Research, Maya MacGuineas of the New America Foundation and I have been studying a reform that would cap the tax reduction that each taxpayer could get from tax expenditures to 2% of his adjusted gross income.

What’s the result? Taxpayers with incomes of $25,000 to $50,000 would pay about $1,000 more in taxes; those with incomes of more than $500,000 might pay $40,000 more.

The cap would affect more than 80% of taxpayers. Although they would continue to benefit from the mortgage deduction, the health insurance exclusion and other tax expenditures, their tax savings would not increase if they took out a larger mortgage or a more expensive insurance policy. Similarly, they would not be penalized and get a lesser tax benefit if they scaled back their mortgage or their health insurance premium by moderate amounts.

A key point to stress about this proposal is that the 2% cap refers to the reduction in an individual’s taxes, not to the size of the tax deduction or exclusion.

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So your AGI at MFJ is $120,000. You have $21,000 in Itemized deductions and $7,300 in exemptions and your taxable income is $91,700 for a tax liability of $15,294. Your tax bill at $120,000 is $22,363. This is a tax savings of $7,069. Two percent of AGI is $2,400. Difference is $4,669. If you allow the exemptions then it is taxable income of 112,700 with a tax liability of $20,538. A difference of $5,244. 2% of AGI limitation is $2,400 for a tax increase of $2,844. To claim that they can still itemize and that they would not be penalized for having a smaller mortgage is being tricky at best. What this does is essentially limit your deductions and give most tax payers just the standard deduction, which in itself could be limited for low income taxpayers. Saying "we won't take away the mortgage interest deduction" and then just capping the tax savings for it is back door trickery worthy of politicans. And then when you make a deduction essentially worthless and then try and sell it by saying "you won't be penalized if you do not have it" is silly. Yes, losing something that is worthless or meaningless does not penalize you. But making it worthless or meaningless does.

Posted by: George W | May 5, 2011 1:05:38 PM

The AMT was devised as a way to give the government a second bite at income that managed to elude the regular tax. This second bite requires a second computation. Now a nice fellow who ought to know better proposes a third bite requiring a third computation. Where will it end? Not with a simple tax system, that's for sure.

These sneaky provisions promote the perception that the tax code is unfair. There is a better way to accomplish something similar: If a deduction makes sense, allow it in full. If it doesn't make sense, repeal it.

Honest taxpayers deserve an honest tax code.

Posted by: AMTbuff | May 5, 2011 12:18:07 PM