Why deduction caps are a great idea

By Felix Salmon
October 4, 2012

If there’s one thing that Democrats and Republicans always agree about, it’s the importance of closing loopholes in the tax code. And if there’s one thing that Democratic and Republican administrations are equally incapable of doing, it’s closing loopholes in the tax code. Every loophole has its associated lobby; many of those lobbies are extremely powerful, and all of them are extremely vocal when it comes to their particular carve-out. And when you have powerful and vocal lobbyists on one side, and no one with much of a dog in the fight on the other side, the powerful and vocal lobbyists tend to win.

Which is why I’m a fan of the capped-deduction idea that Mitt Romney first floated on Tuesday, and then brought up again in the debate last night. Here’s what he said on Tuesday:

As an option you could say everybody’s going to get up to a $17,000 deduction; and you could use your charitable deduction, your home mortgage deduction, or others – your healthcare deduction. And you can fill that bucket, if you will, that $17,000 bucket that way. And higher income people might have a lower number.

And here’s what he said in the debate:

I want to bring down the tax burden on middle-income families. And I’m going to work together with Congress to say, OK, what — what are the various ways we could bring down deductions, for instance? One way, for instance, would be to have a single number. Make up a number, $25,000, $50,000. Anybody can have deductions up to that amount. And then that number disappears for high-income people. That’s one way one could do it.

Romney’s a step ahead of his campaign, here. When pushed for specifics, spokeswoman Andrea Saul has nothing, saying only that “Gov. Romney referenced one illustrative example” of a way in which he might possibly get revenues without raising taxes. The lack of detail was immediately seized on by the Obama campaign, which decided that if Romney wasn’t going to be specific, then it obviously had to include the healthcare exclusion — the way in which Americans don’t pay taxes on health-insurance costs borne on their behalf by their employer.

But Romney never mentioned exclusions, only deductions. This is hair-splitting territory, but if you’re the kind of person who itemizes your deductions, you know what you’re deducting. The big ones are your state and local taxes; your charitable contributions; and your mortgage interest payments. Meanwhile, you probably don’t even know how much your employer is spending on your health insurance.

And frankly I’m disappointed in the Obama campaign’s response: they’ve come out, now, with a simple argument: any attempt to cap deductions would constitute a middle-class tax hike. Obama won’t raise taxes on the middle class. Therefore, Obama is opposed to any attempt to cap deductions. That’s sad, because in principle the idea is a very good one. And it’s also sad because it reveals that the Obama campaign simply isn’t serious about closing loopholes.

After all, there are lots of ways to close loopholes in a revenue-neutral way, so that the middle class in aggregate pays no more taxes than it does right now. But if you’re attacking deductions, then by definition the people who take those deductions are going to lose out. And if you’re promising that no individual middle-class family will see their taxes rise, then frankly you’re not being serious about tax reform at all.

The Tax Policy Center has an excellent overview of who itemizes deductions. Overall, there are about 158 million “tax units” in America, of whom about 47 million itemize deductions at all. That’s 30% of the total. And if you slice off the people with incomes in the top 20%, then you’re left with 28 million tax returns which itemize deductions out of 135 million returns filed, which is basically just one in five. You could completely eliminate all tax deductions tomorrow, including the horrible mortgage-interest deduction, and taxes wouldn’t rise for the vast majority of Americans. But if you commit to not raising taxes for those 28 million households who do deduct, then you’re never going to get anywhere.

And the Romney approach is a really good one because it dilutes the power of any individual lobby. He’s not picking favorites here, retaining the charitable-contribution tax deduction, for instance, while abolishing the mortgage-interest deduction. He’s saying that you get to keep whatever deductions you like — just up to a certain limit. Martin Feldstein has proposed something similar: his 2% cap would raise $278 billion, which is real money. And Romney actually goes further than Feldstein: instead of the cap rising with income, as Feldstein’s does, Romney’s falls with income, and indeed it entirely “disappears for high-income people”. If you’re high-income, you get no deductions at all.

This would have a massive effect on Romney himself, who gives millions of dollars to charity every year. What he’s saying — and this is a praiseworthy and honorable thing — is that he gives to charity because it’s the right thing to do, rather than because he gets to donate pre-tax dollars. He will continue to give to charity, even if the charitable tax deduction gets abolished, and he will continue to minimize his taxes, as is his right. But he’s just not going to be able to do both at the same time any more, which is fine.

What’s more, the cap on deductions is a bit like the emissions cap in a cap-and-trade system: once implemented, it can be dialed up and down relatively easily. Any time you need a bit more on the revenue side of things, you dial it down. Any time you want to be able to say that you’re doing wonderful things for charities and non-profits, you dial it up. (And in doing so, you’ll get a very handy natural experiment: we’ll really see, with hard empirical data, just how many marginal extra charitable cents get donated for every dollar of charitable-deduction tax expenditure.)

I don’t believe for one minute that even a complete repeal of all deductions would be enough to counteract the 20% across-the-board tax cut that Romney says he wants. But that’s where scoring comes in: presidential candidates can say whatever they like, while presidents, if they’re proposing something revenue-neutral, need the CBO to score it that way.

Romney came out and said, in the debate, that “you’ll never balance the budget by raising taxes” — which is equivalent to a businessman saying that you’ll never increase your revenues by raising your prices. I don’t take his fiscal-policy rhetoric seriously, and I don’t know anybody who thinks it adds up. But all the more reason, then, to welcome sensible proposals when they do occasionally emerge from his camp.

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Comments
26 comments so far

Oh, it was so very good, until that last paragraph – but it’s still damn good. Better if the end of the first sentence read -

‘- which is equivalent to a businessman (correctly) saying you’ll never turn a losing line of business around by simply raising prices.’

The way things are arranged, it’s just not in the cards to balance the budget without substantial growth. Shouldn’t be that way – but it is.

Posted by MrRFox | Report as abusive

Allowing a maximum on deductions, or better yet, allowing everyone a $25,000 deduction, is a great idea. Obama should commend Romney for suggesting such a plan, and then watch Romney backtrack, as his supporters remind him that he is supposed to lower their taxes, not raise them.

Then we can add this idea to the health care plan, cap and trade, the Economic Stimulus Act (under bush), and other ideas all proposed by Republicans, but rejected by them once they were accepted by Obama (http://www.newyorker.com/reporting/2012  /06/25/120625fa_fact_klein?currentPage= 2)

During last year’s debt limit crisis, Obama suggested a draconian spending reduction plan that could have spurred a primary battle for him. And yet the Republicans rejected it. He has a great opportunity to put their obstructionism on full display by embracing this proposal from Romney, and watching them squirm out of it.

Posted by KenG_CA | Report as abusive

I actually love this idea but what do you think the chances are that it might actually get implemented if Romney gets voted in. It starts out as a cap with no exceptions and then turns into a cap with only 54131561 exceptions by the time it gets signed into law.

Posted by spectre855 | Report as abusive

If Obama agreed to a cap or explored it as part of a debate or a campaign speech Rs would be on him so fast for proposing a tax hike your head would spin. You might hate it, but Obama’s response is the right one before an election. This is why dishonest discourse often results in no discourse at all. Sorry but that’s the way it is.

Posted by rb6 | Report as abusive

It is a shocking idea, but you would also have to implement it for corporations too or everyone affected will incorporate to take advantage of them, so why don’t we start by applying it to corporations?

Posted by MyLord | Report as abusive

Know what is sad? Romney floated an idea and it is what people talk about all day. Know what I am a fan of? The truth. Child tax credits? Married couples? What loopholes would he open for the rich in lieu? What loopholes is he going to close? Those details are so dull and boring! Charity bucks are a non issue, according to the Republican plan on the website, so In all “fairness,” this speculating is a distraction that worked a charm!

This “proposal” isn’t on Romney’s website. I have a vision of a political cartoon. Romney looked and sounded like he was hepped up on Redbull so, I liken Romney’s debate persona to a red-eyed, panting, raving flasher, who opened his coat and instead of seeing he was naked and run screaming… everyone wants to look at the cheap watches he has for sale in his pocket linings.

Romney has a lot of watches and he switches them out depending on the audience. Last night he had the most watches on display, so you got a good peep show…and today you’re dazzled by the shiny new ‘Rollex.’

Next debate act, snake oil salesman bit, where he will not only have new watches, but some magic elixirs for you to buy and be sad Obama didn’t drink. He might even tell you that removing the estate tax will ensure his grandchildren get all the money and will save the world! And pay more taxes in their higher tax bracket, just like Grandpa and his tax advisers have shown they could do!

(The third one will have Romney doing the limbo as he shows you on an erasable how to do voodoo tax accounting. I won’t be missing that show for the world!)

Posted by youniquelikeme | Report as abusive

I’m on board with most of this, and agree that a deduction cap could be a politically savvy way to reduce deductions. It’s just good thinking.

I’m less excited about the charitable deduction getting lumped into the rest of them. (I know what you’re thinking, “Here we go.” Cut every deduction but mine, right?)

The difference is that the sums given to charity by the top 10% are more than the other 90% combined. This matters because donations to charity are deductible up to 50% of income for a year. A million/year income earner can give away $500k tax-free. (This kind of thing happens a lot.) Although the demand for donations are probably tax-price inelastic, like the Economist pointed out a few months ago, the tax incentive certainly has *some* effect.

There’s no other deduction that is anywhere close to as generous in promoting a particular activity, except for maybe unique cases like people (*cough* Romney) who invest heavily in muni bonds. You’d need the most expensive mortgage on earth to even come close to the charitable deduction limit with the mortgage interest deduction, and that’s the next biggest for most people.

Of course, I’m all on board if you convert the charitable deduction to a tax credit, which is more equitable and insensitive to tax rate. :)

Posted by thefinite | Report as abusive

I forgot to add that most charitable donations have a qualitatively different potential for generating public goods than any other deduction. (Rich charities that benefit the rich excluded.)

Posted by thefinite | Report as abusive

thefinite, if you give a deduction, or worse, a tax credit, for a donation to a church, then the government is effectively making that donation. I would be as offended by that as the Koch brothers would be for my donations to the NRDC. A tax credit says you get to spend the country’s money. That would virtually eliminate all taxes, as people would get to donate what they owe to their favorite charity, instead of paying taxes.

Posted by KenG_CA | Report as abusive

Regarding thefinite’s point on the tax exemption on muni bond interest – it’s clear comparing interest rates on muni bonds and equivalently-rated taxable bonds that almost all of tax benefit on muni bond interest goes to the municipal borrower.

As a technical matter, it’s also unclear if Romney’s proposal would impact this, since tax-free muni bond interest is not a “deduction” from income but simply isn’t included in income. Politically, I would say there’s zero chance that the federal government increases revenue by taxing muni bond interest because every state and municipal government in the country would oppose it. (Maybe the entire system would shift to look like Build America Bonds where bond interest is taxable but the federal government pays a subsidy equal to 35% of interest to the municipal issuer, which net would be essentially a wash for the federal government.)

Legally, the federal government presumably can tax muni bond interest – a Supreme Court decision in 1988 reversed a Supreme Court decision that had held the opposite in 1895 – but I assume there would be suits by states regarding that point.

Posted by realist50 | Report as abusive

I was not a fan of Mitt’s plan when it was floated with a $17,000 cap — that would easily capture a lot of middle-income people who experience a medical surprise. And who didn’t think that the $17,000 was an odd number to begin with?

At $50,000, it works well. But let’s not be naive: if Obama had proposed it, Republicans would have opposed it.

Posted by GRRR | Report as abusive

Mortgage interest is already capped at $1M, not really that high. The big one is tax deferred retirement accounts so this would be taxing people when they earned it, not when they want to withdraw it. State but especially property taxes would be large and would pressure property values, that and state and municipal bonds would make it hard for local governments and school districts.

Posted by MyLord | Report as abusive

KenG, most tax credits are just a percentage of the gross, e.g. 25%, not a fully-offsetting tax credit.

What proportion of households itemize at all? I’d be happy enough to simply eliminate schedule A all together. The vast majority of the benefits from itemizing flow to the wealthy.

Posted by TFF | Report as abusive

MyLord, if you tax 401k and pension plans, then people will stop contributing entirely. I like that idea as well, but it would be a very different economic environment.

Posted by TFF | Report as abusive

Romney: “As an option you could say everybody’s going to get up to a $17,000 deduction; and you could use your charitable deduction, your home mortgage deduction, or others – your healthcare deduction.”

Felix: “The lack of detail was immediately seized on by the Obama campaign, which decided that…it obviously had to include the healthcare exclusion — the way in which Americans don’t pay taxes on health-insurance costs borne on their behalf by their employer.

But Romney never mentioned exclusions, only deductions. This is hair-splitting territory, but if you’re the kind of person who itemizes your deductions, you know what you’re deducting. The big ones are your state and local taxes; your charitable contributions; and your mortgage interest payments. Meanwhile, you probably don’t even know how much your employer is spending on your health insurance.”

If you have to lie that much to make Romney sound sane, Felix, you need to quit your job. It’s not good for your health.

Posted by klhoughton | Report as abusive

You forget why Romney needs so badly to do this, his huge tax breaks. He can’t posture about the deficit unless he promises to offset those tax breaks.

Everyone always wrings their hands about the deficit. “What are we going to do?” they helplessly whine. We have financed a first-world infrastructure: highways, airports, universal high school, a massive freaking eighth-wonder-of-the-world kind of army, several wars, and two large health insurance companies (Medicare and Medicaid) that for some reason only cover people who are very likely to either be sick, poor or both. We have done this for thirty years while half of our political class shrieks about how will never, regardless of justice or need or moral imperative, raise taxes. They fight to lower them whenever they can. And they have succeeded often. Americans do not pay a first world tax rate. We need to get over it, and agree as a society that we will pay what it costs to run our government. We can do it as a democracy, together- because the minute you start asking individuals everyone goes all tragedy of the commons. We need to summon the spirit of Elinor Ostrom and make her tell us how to convince the electorate to take care of ourselves… Then we can worry about the shrieking of the spin machine.

Because anything that would generate enough revenue- that includes deduction caps- to make up for the kind of tax cuts that Romney wants (let alone touches the deficit) will make lobbyists and special interests squeal in ways that would embarrass swine.

Posted by http | Report as abusive

TFF, you’re right about that, but I still don’t like the idea of credits or deductions for every charitable contribution. In many cases, it violates the separation between church and state, as it effectively has the government contributing to religions.

Posted by KenG_CA | Report as abusive

I am in approximately the 65 income percentile of US households (top 5 percent of globally.) I get:

15,000 in retirement contributions on which my taxation is deferred into the future.

14,000 in mortgage interest on a 1st home.

12,000 health insurance deduction (half that amount if you exclude the share paid by my employer.)

8,000 worth of deductions (which are really 2k in credits multiplied by the inverse of my marginal rate.)

So I have roughly 50,000 in deductions. TFF accurately points out that I pay property taxes, sales taxes, state income taxes… but the feds get only a modest contribution from me.

In the 65 percentile of income my federal government spends 4 times what they collect from me per capita. That’s a fairly progressive system as it stands.

Posted by y2kurtus | Report as abusive

I’m sorry, but I am missing the point of lowering headline rates and then introducing a deduction cap that depends on income. Start with state tax deduction. That has the effect of lowering effective state marginal tax rate. If I reduce the federal rate but eliminate state deduction, that just (partially) offsets reduction in my federal rate with an increase in my effective state rate. What’s the benefit compared to a smaller reduction of federal rate and preserving deductibility.
Phase out of total deductions is even more perverse: it introduces a upward bump in the effective tax rate over the income range of the phase-out, which then disappears for higher income. So you end up with a marginal rate for the highest earners that is lower than those whose earning are in the phase-out range.
This stuff just adds complexity without accomplishing anything – if you think the rate cut loses too much revenue, cut rates by less.
I’m fine with limiting the mortgage deduction if we want to limit subsidy to mortgages – but cap it for everyone. Same with charity. These things are not “loopholes” – they are deliberate tax expenditures for specific purpose, if we don’t think the purpose is worth the cost, limit or get rid of it. But making the amount deductible depend on income just introduces weird marginal rate effects which defeat the (presumed) purpose behind lowering marginal rates.

Posted by srb4761 | Report as abusive

The bottom line is the tax rate should be a levy dependent on the spending, solves all these problems. Then the politicians can just bicker about how the levy is distributed, but there won’t be any more handing out of goodies without people paying for them.

Posted by QCIC | Report as abusive

The middle class is usually defined as the middle 3/5ths of the income curve.

If you split out each 3rd of the middle class you learn that the lower middle is mostly untaxed at the federal level. Payroll taxes are meaningful but do not even cover the direct benefits tied to them. This leaves basically no contribution for any discretionary spending.

It is much more complicated for the middle middle and upper middle. Some like me pay almost nothing due to broad categories of the largest deductions. Childless renters who don’t provide for their own retirement are badly discriminated against by the current code.

One could quite accurately point out that a society made up exclusively of childless renters who don’t provide for their own retirement would fail within 1 generation… but rather than get into that counterproductive debate… I’ll just admit that as a group, people in the upper half of the middle class DO NOT PAY THEIR FAIR SHARE in the current system.

Posted by y2kurtus | Report as abusive

Felix,

I would like to step back and ask why you think “tax reform”, and especially tax reform centered on lowering rates while trimming deductions, is a good idea. Why do you think it’s a good idea?

Possibilities include:
1) eliminating wasteful deductions and credits that were maybe once a good idea but which are no longer worth their cost;
2) providing a more transparent income tax system so that workers can properly assess the marginal benefits and costs of earning higher wages;
3) cost savings from simplified tax filings; and
4) ?

It seems to me that the $17,000 cap on deductions, while a politically elegant way to limit deductions without battling over specific deductions, serves no practical purpose. At least it does not seem to accomplish any of the goals I’ve listed above.

Why would a tax system with marginal rates that are, say, 5% or 10% lower, coupled with even more complexity around deductions and credits, be a better tax system?

And if we are looking to have revenue neutral tax reform (which apparently everyone in Washington has agreed to), isn’t the only point to enact a system that is in some way “better”? Why else are we shuffling chairs around?

Posted by andersb | Report as abusive

@andersb, I would offer a few possibilities (some of what you touch on).

(1) Law of unintended consequences. Credits/deductions are frequently a ham-handed attempt to manipulate economic behavior, or to make the system “fairer” for some disadvantaged group. Yet for every inequity they resolve, two new ones are created. Could argue that tax policy contributed to the mortgage bubble.

(2) Simplicity. Shouldn’t require a college degree and a $40 computer program to file your taxes (we don’t do anything terribly unusual). These days, nobody but an expert is aware of all the possible deductions/credits out there.

(3) Transparency. Better for all if people can trust that everybody is paying their fair share. If they suspect the system is slanted to the advantage of somebody else, they get resentful.

Posted by TFF | Report as abusive

@TFF

But are any of those three things accomplished with a deduction cap in the range of $17,000 per year?

1) the existing distortions caused by things like the mortgage interest deduction (or the arguably more problematic exclusion from income for employer provided health insurance) will nearly completely stay in place. Arguably they will completely stay in place because taxpayers / potential home buyers will not understand the impact of the deduction cap.

2) simplicity? This proposal would simply add a layer of complexity. It would be very difficult to know, in the early months of a given year, whether a particular payment will be eligible for an income tax deduction. And when it comes time to prepare one’s taxes, you would have to first enter your itemized deductions (and all the work that entails) and then check to see whether the cap impacts your results. (and then on top of that still have to work through the alternative minimum tax).

3) I don’t see how transparency is changed much here. It might even be worse if the cap applies to a bunch of households in the $150k-$300k income range while people like Romney continue to pay a 15% tax rate on nearly all of their income. Additionally, the cap would presumably not apply to ordinary and necessary business deductions, so there would still be anecdotes about small business owners taking tax deductions for cars and phones mostly acquired for personal use.

I don’t mean to say that the goals you have identified are unworthy goals. Quite the opposite actually – I think they are right on the money.

However, I don’t think the deduction cap idea materially advances any of them (unfortunately).

Posted by andersb | Report as abusive

@andersb, I would rather eliminate the deductions, exclusions, and credits all together. I agree that a deduction cap would further complicate the system (never a positive).

No system will ever be wholly fair, so you might as well stick with something simple. We have seven different pre-tax deductions from our paychecks, four or five different major items on Schedule A, and a handful of credits which each come with a different cap or phase-out. We can’t even calculate the tax owed without going through a page-long form on the back of Schedule D.

Posted by TFF | Report as abusive

I agree with the theoretical benefits of eliminating exclusions and deductions. (Although I am concerned about the distributional effects of such a plan; it seems highly likely that the middle 3/5s of the country would have to pay more in federal taxes to make the math work. If we could raise the tax on capital gains and dividends up to the 25% range at the same time, I’d probably be more bullish.)

My point here though is that I don’t think a deduction cap accomplishes any of the goals of tax reform centered around lowering rates and eliminating deductions. We now seem to be in agreement on that as far as I can tell. The “seven different pre-tax deductions” would still be on your paycheck, as would the other deductions and credits. The phaseouts would likewise still apply.

The only potential accomplishment that I see is a (modest) lowering of marginal rates. But I don’t see why that is necessarily a positive thing if the effective rates don’t change much (they would go down for some people and up for others). How many Americans have any clue what their marginal tax rate is? And what subset of those people make decisions about working more, or making deductible payments, based on that rate?

Lastly, and mostly unrelatedly, why does Romney get to go around touting a 20% tax “cut” that he claims is revenue neutral? Either he is proposing a tax cut or he is proposing revenue neutral reform. It can’t be both.

Posted by andersb | Report as abusive
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