Cap deductions rather than raise tax rates

Cap deductions rather than raise tax rates

America’s presidential election was supposed to be a head-clearing referendum on the size of government. It was not: voters split their vote, giving Barack Obama a second term and Republicans in the House of Representatives another big majority. Yet in one respect the election has clarified matters. Mr. Obama has long argued that repairing America’s finances will require raising more tax as well as cutting spending. Influential Republicans, most importantly including John Boehner, the Speaker of the House, now appear to agree.

This comes not a moment too soon. In less than two months America will reach a “fiscal cliff”, when George W. Bush’s tax cuts will expire and automatic spending cuts will take effect. The economy could suffer a fiscal tightening of as much as 5% of GDP over a full year, easily enough to bring on recession.

Before any deal to avoid this can be struck, though, big issues must be resolved. What categories of spending are to be cut? And, on the revenue side, which taxes should go up? Ever since taking office, Mr. Obama has pressed to make Mr. Bush’s tax cuts permanent for 98% of households while ensuring that the wealthiest 2% pay more. Mr. Boehner says that tax rates should not go up for anyone; but he is open to raising revenue by eliminating tax breaks. The good news is that there may be a deal to be had that meets both objectives.

Returning the two top marginal rates to 36% and 39.6% from their current 33% and 35% would hardly capsize the economy, but it is not the most efficient way to raise revenue. At the margin, higher rates discourage work and investment and encourage tax avoidance. It would be better to revamp the tax code, starting out by leaving marginal rates alone and instead raising revenue by curbing the deductions and exemptions that pockmark the system and cost the Treasury as much as $1 trillion a year in forgone revenue. These “tax expenditures” are camouflaged government subsidies and create damaging distortions: the mortgage-interest deduction, for instance, encourages supersized houses and debts to match; the charitable deduction forces taxpayers to subsidies everyone else’s pet cause, whether that be Planned Parenthood or the George W. Bush presidential library; and the tax break for employer-provided health insurance helps fuel the relentless rise in health-care costs.

Cap in hand

There are many routes to reforming these exemptions. One would be to single out particular tax breaks for elimination. But the likelihood is that the process would crumple under the onslaught of lobbyists who defend every loophole, resulting in too many exceptions and too little revenue. An easier first step would be to cap all deductions, an approach advanced by none other than Mitt Romney. Set at $50,000 such a cap would raise some $750 billion over ten years, estimates the Tax Policy Centre, a think-tank—more than would be obtained by restoring the top two rates to pre-2001 levels. The cap would barely touch the bottom 60% of taxpayers while only slightly hurting the upper-middle class. Most of the money would come from the top 1%. If such a cap were agreed to now but did not take effect until 2014, that would allow time for charities, employers and others to plan—and for the details to be tweaked as part of a bigger deal also involving much bigger spending cuts, especially to the huge unaffordable entitlement programs.

The overall target is to save $4 trillion over the next ten years. Mr. Obama is still sticking to the idea that $1.6 trillion of that should come from higher tax revenues and he is still focusing on raising rates. That may be a negotiating tactic, but it would be much better if he began with the deductions.

Source: The Economist