Though it is hard to tell exactly how the fiscal cliff tug-of-war will end, what we can say is that Democrats and Republicans have been drearily unimaginative. President Obama wants to see the top two federal income tax rates increase above their current levels.
Obama has called for a top rate of 39.6 percent, though he has signaled a willingness to compromise on a somewhat lower rate. While he has said he is open to entitlement reform in some vague way, he has so far refused to be pinned down on the details. Essentially, he is asking congressional Republicans to make a big concession on taxes and to trust that he will honor his end of the deal by agreeing to embrace spending restraint in 2013.
Republicans are by and large opposed to a top tax rate above today’s 35 percent. Though they too have been light on details, many have instead embraced sharp limits on popular tax exemptions for high earners to raise revenue. Others have suggested they’d be willing to budge on tax rates. Representative Tom Cole (R-OK) has called on his fellow House Republicans to pass two bills, one that extends the Bush-era high-income rate reductions and another that extends everything else, with the understanding that the latter will become law while the former will fall into oblivion. This strategic retreat is designed to allow Republicans to use the forthcoming fight over the debt limit to secure, among other things, a hike in the Medicare eligibility age.
Rather than see Obama’s insistence on new revenue as a defeat in the making, Republicans could treat it as an opportunity to advance conservative policy goals. One of the most costly tax expenditures, for example, is the deduction for state and local taxes, which in effect subsidizes high-tax jurisdictions by softening the blow of high state and local tax burdens. Eliminating this deduction would make voters in states such as New York, New Jersey and California more tax-sensitive, which might make them more likely to back state and local candidates who promise a more cost-effective government.
Elimination of the deduction would also be a bonanza for the U.S. Treasury. In fiscal year 2011, the state and local tax deduction cost the federal government $70.2 billion in forfeited revenue. In April, the Committee for a Responsible Federal Budget estimated that eliminating the state and local tax deduction would raise $1.3 trillion relative to current policy (the tax rates that prevail today) and $950 billion relative to current law (the tax rates that will be in place if we go over the fiscal cliff) from 2013-2022. This alone would go a long way toward meeting Obama’s revenue goals. Even if Congress only eliminated the state and local tax deduction for households earning $200,000 or more, it would raise $500 billion relative to current policy.