Don’t fight a tax on deductions

By Felix Salmon
December 17, 2012

James Stewart has a long attack this weekend on the one idea from the presidential campaign which managed to receive genuine bipartisan support: the cap on deductions. He’s a first-rate reporter and columnist, so it’s worth going into some detail about all the different places he’s wrong.

Stewart starts off his column by summing up his two main arguments against a cap on deductions:

Without addressing larger tax preferences, like a lower rate on capital gains, it does almost nothing to cure the so-called Buffett problem, in which Warren Buffett’s secretary pays a higher effective rate than her billionaire boss. It doesn’t even raise much revenue.

Saying that a cap on deductions doesn’t cure the Buffett problem is a bit like saying that some random bit of Dodd-Frank doesn’t solve too-big-to-fail, or wouldn’t have prevented the 2008 financial crisis. It’s true, but it’s irrelevant. You can’t approach the current fiscal negotiations with the idea that solving the Buffett problem is a necessary precondition for any fiscal-policy tweak: you’d never get anywhere if you did. The task right now is to come to an agreement on a set of policies which will raise revenues and cut expenditures; a cap on deductions does exactly that. And what’s more, while it won’t mean Warren Buffett paying a higher tax rate than his secretary, it will at least reduce the distance between them.

As for the idea that a cap on deductions “doesn’t even raise much revenue” — well, that’s in the eye of the beholder. The dog not barking here is that Stewart never actually comes out and say how much money a cap on deductions would raise. Here are the numbers, from the Tax Policy Center: a cap at $50,000 would raise more than $700 billion over ten years, while a cap at $25,000 would raise some $1.2 trillion. That’s real money. Even if you exempt charitable donations from the cap, you’re still raising almost $500 billion at the $50,000 level, and more than $800 billion with a $25,000 cap.

Stewart is at least honest about the main reason he opposes this cap:

It would hit people like me: taxpayers in higher brackets who rely on earned income as opposed to investment income or an inheritance, who give to charity and live in a high-tax state. Assuming a $35,000 limit on itemized deductions, my federal tax last year would have risen to 27 percent of my adjusted gross income, from 22 percent.

Stewart talks about his own personal tax rate a lot in his column; he must think it’s of great interest to the rest of us. Interestingly, he always talks about his tax rate as a percentage of his adjusted gross income, which is surely a lot higher than his tax rate as a percentage of the total amount of money he makes every year. (As a self-employed professional, Stewart can take a large number of expenses, including housing expenses, and deduct them from his income before calculating any tax at all.)

Stewart’s point is absolutely correct, as far as it goes. The three major deductions are state and local taxes; mortgage interest payments; and charitable contributions. So people who spend a lot of money on those three things every year — people like Stewart — are going to be precisely the people who are most hit by a cap on deductions.

At the same time, however, Stewart is rich, and everybody knows that the rich are going to have to pay more in taxes, one way or another. Indeed, Stewart says he’s OK with that: he claims that he “wouldn’t mind paying more” in taxes, just so long as the top 400 taxpayers in the country all paid more in taxes as well.

But here’s the thing — they would! According to Stewart’s own calculations, the taxable income of the top 400 taxpayers would rise by $32 million, on average, while their overall tax rate could go up to 25% from 20%. Seems like a big hike to me. But because that 25% is lower than Stewart’s own 27%, he’s decided that we’d be better off not capping deductions at all.

This is profoundly myopic. I can see how on a philosophical level it makes sense to ask the top 400 taxpayers in the country to pay a higher tax rate than James Stewart. But the top 400 taxpayers are, by definition, a highly exceptional bunch, who spend millions of dollars a year on tax-avoidance strategies. It might or might not be possible to construct a tax regime which makes the top 0.0001% pay a higher tax rate than James Stewart, but I really don’t think that failure to do is reason to do nothing at all.

Maybe realizing that he’s on to a losing argument here, Stewart shifts course at this point, describing the deduction cap as “a stake aimed at the heart of the charitable deduction”. And once again, the dog doesn’t bark: he quotes lots of people who work in the non-profit sector, saying that this move would reduce the amount of money that people give to charity. But not once does he hazard a guess at the amount by which charitable giving might decline; indeed, he quotes Patrick Rooney, of the Center on Philanthropy at Indiana University, as saying that he hasn’t studied that question.

Rooney has studied similar questions, however. For instance, his institute looked at the effect of capping the deduction at 28%, even for taxpayers with a higher marginal tax rate. That tweak would reduce charitable giving by some $2 billion per year, they found — but it would raise ten times that amount in new tax revenues.

And when the CBO recently looked at various different ways of changing the charitable tax deduction, they came to much the same conclusion:

In each case that CBO examined, the reduction in the subsidy (and thus the increase in revenues) would exceed the reduction in charitable contributions, whether measured in dollars or as a percentage change.

If there’s one constant when it comes to the charitable deduction, it’s this: its opponents love to get quantitative, while its defenders generally refuse to talk numbers at all. For instance, check out Bob Shiller’s column this weekend: despite the fact that he’s a fine economist, he never once talks costs and benefits, instead relying on general principles such as the one saying that “income that is freely given away should not even be considered as taxable income”. And then compare Dick Thaler, or any of the many other critics of the charitable deduction: they ground their arguments in reality, rather than in the clouds.

So when Stewart starts saying that capping deductions will hurt the poor, on the grounds that the poor go to hospitals and museums, and those hospitals and museums are reliant on charitable donations — well, take it all with a pinch of salt. And move on to Stewart’s next argument, which revolves around the deductibility of state and local taxes:

According to the Census Bureau, state taxes per capita in 2011 ranged from $3,491 in New York to $1,674 in South Dakota. For many higher-income taxpayers in high-tax states, state and local taxes alone would exceed the cap limit, completely depriving them of the mortgage and charitable deductions.

This is an interesting use of the word “many”. If the cap was put at $25,000, that would be more than seven times the average state taxes in the state with the highest taxes in the union. If the cap was at $35,000, it would be more than ten times New York’s average state taxes. So yes, if you pay ten times the average amount of taxes in your state, and if you live in New York, then you might use up all of your cap with state taxes alone. You’ll excuse me if my heart doesn’t bleed.

Stewart concludes by reiterating that he would rather see other people pay more in taxes, rather than himself — especially people who rely less on income and more on capital gains. I’m inclined to agree with him, on a policy level: I too would like to see unearned income taxed at the same rate as earned income. But the fact is that all the big deductions — charitable, mortgage-interest, even state and local taxes — are bad public policy. We should cap them, at a high level if necessary, and then bring down the cap over time, until it reaches zero. That, in turn, will help income tax rates to converge on capital-gains tax rates, again over time. Few things in fiscal policy happen overnight. But capping deductions is a step in the right direction. And Stewart should embrace that, rather than fighting it.

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