A Small But Important Point Re A Fiscal Cliff Solution

November 25th, 2012 at 11:18 pm

The idea that we could raise needed revenue by capping deductions of high-income families as opposed to raising their tax rates is gaining some traction (economist Greg Mankiw supports the alternative in the NYT this AM).  For example, suppose households were allowed to deduct only $50,000 from their annual tax bill.  Since wealthy families usually deduct a lot more than that, this would be a progressive way of gaining new revenue (though there are arguments about how much–certainly, well under the President’s $1.6 trillion opening bid).

But if this approach were limited to households above $250,000, as would likely be the case given that both sides have vowed to protect the “middle class” from higher taxes, there’s a real problem with it: you create another–dare I say it–tax cliff.*

Under the  higher rates approach, only the marginal dollar above $250,000 is taxed at the new, higher rates.  So a household that earns just above the threshold won’t notice the change.  But if their deductions were suddenly capped, they’d notice it big time.  Imagine a household earning $249,000 and deducting  $70,000 from their taxes–if their income then goes over the threshold, they’d face a $20K tax increase.  The only fair way to solve this is to phase in the capped deductions, which of course leads to revenue loss.

So I’m not saying it’s a bad idea, but if we’re talking about just applying it to the wealthy, it’s more complicated a) than folks are saying, and b) relative to the expiration of the Bush cuts for the top 2%.

*Note that the TPC estimates that a $50K cap on the deductions of all families would raise about $750 billion over 10 years, so about half of the President’s revenue ask.  If the cap were restricted to families above $250K, we’d raise $200 billion less, so this idea clearly does not hold the “middle-class” harmless relative to the expiration of the upper-income cuts.

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14 comments in reply to "A Small But Important Point Re A Fiscal Cliff Solution"

  1. NP says:

    The only fair way to do this is to cap everybody’s deductions. For example if you made the cap $100,000 this would only affect the very wealthy and not affect people making less than two or three times this amount.

  2. Michael Olsen says:

    I think the proposal is merely to cap itemized deductions at $50,000, whatever your income. That solves your problem, no?

  3. Sue says:

    My impression was that Mankiw was advocating the $50,000 deduction cap for ALL taxpayers, not just those making over $250,000. This is from the New York Times article:
    “According to the Tax Policy Center, if we cap itemized deductions at $50,000 and keep tax rates as they are today, we’d raise $749 billion in tax revenue over 10 years.”
    So the idea would be that it’s progressive, because you have to be pretty wealthy for the cap to have an impact; it’s simple, because the flat amount applies to everybody; and it avoids the special interest lobbying against eliminating specific deductions.

    Another approach that sounds intriguing was proposed by Dylan Matthews:
    and involves giving a flat credit (say 20%) for charitable donations, e.g., which solves the problem of running up against your deduction cap and deciding not to donate any more.

    Neither of these approaches raises enough revenue, and I’m still in favor of the tax rates on the wealthy reverting to Clinton-era levels, and especially restoring a reasonable estate tax, but these reforms should be considered, too.

    • Jared Bernstein says:

      I think you’re right but then you run into raising tax liabilities on HHs below 250K–which may be a big deal given the pledges not to do so.

  4. Hariharan Vijay says:

    Hang on – if you’re suddenly capping deductions at $50K, a $250K+ family previously deducting $70K doesn’t face a $20K tax increase – they’re facing a $20K deduction decrease. That they’d have to pay taxes on that additional $20K, and so would be facing around a $6K tax increase (depending on what their marginal rate is).

    Your argument makes sense regardless, you’re right that it needs to be phased in to not be onerous. But a $6K increase vs a $20K increase is very different.

  5. Denise says:

    I wonder why anyone is concerned with a so called ‘balanced’ response to a problem clearly brought on by those responsible for keeping wages at an unlivable level for the past 30+ years while amassing great fortunes for themselves. It drives me crazy to hear the phrase “make the rich pay a little more”. Start at the top .01% and raise their taxes to 50%, close ALL loopholes for them and work down to closing all loopholes on top 2% of corporations and those who make over $250k. From top tax bracket of 50%, work down to 38% for those at $250k. NO compromise. Make it illegal to manufacture weapons of mass destruction and sell them to all sides. Many of these richest (Koch Bros, Waltons, Exxon, etc) are dangerous to the health of the planet and all trying to live happily for the short time we have. Our first priority should be the health of the planet. Our brilliant military would be better off working on these problems, not making profits for Halliburton and the other war profiteers. We need to change our perceptions and fast.

  6. Jill SH says:

    Rather than a fixed amount deduction cap, why not a percentage of income cap in reversed graduation? Maybe no deductible limit at the lowest tax bracket, and 0 percentage at the above 250k/500k/1M (pick a number) level?

    That way those of us who pay extravagant property taxes (30% or more for low/fixed income households in states like NH!) get an escape hatch, and those with much greater means don’t hit a cliff when they get to that upper bracket.

  7. Bob Wyman says:

    A cap on deductions would be a big win for small-government, anti-Federalist conservatives since it will tend to limit the ability of government to influence economic decisions via the tax code. The R’s now realize that some additional “revenues” are inevitable and that the wealthy will need to contribute more. Thus, they are focusing on the one mechanism for raising additional revenues that will most reduce the impact and influence of government. It is a compromise. They are “giving” on the revenues but in return they are “getting” a reduction in the government’s power. Since new revenues now seems inevitable, they are giving very little but they are getting something very significant.

    Unfortunately, the Democrats seem to think this debate is simply about “the fiscal cliff” and general economic issues. What they don’t seem to realize is that the debate over deduction limits is really a debate about the role and scope of government.

  8. netbacker says:

    I don’t understand why everyone starts off with the premise that revenues needs to be raised. This is wrong when it comes to Federal govt finances.
    A sovereign nation like the US, which has its own currency, is not revenue constrained. Where do you think these dollars come? The only entity that can legally create these dollars is the federal govt itself. It is not borrowed from someone to begin with.
    A spending cut or as you propose a deduction cut is equivalent to a tax increase.

  9. JTK says:

    This deduction cap is just bad policy. It’s the ultimate triumph of politics over substance, unfortunately. Like it or not, some deductions are actually at least somewhat legit. On another front, Jared, are you of the Grand Bargain skeptic club? I feel that they should break up all these issues into smaller pieces. For instance, overhaul BCA by itself, and most obviously, patch the AMT separately. Then do the dance with the devil over entitlements and the core tax code.

  10. Steve says:

    I know this is selfish but here is my input on the capped deductions. We are in the 115-125k annual family income range. We are sending one of our children to a private university. At 53k+ annual for tuition and expenses we are using every last penny and then some to make it. With limited financial aid at our income level we need the education tax credit along with our home mortgage deduction, sales tax credit, etc. In the end this means that for several years we are way above the average tax deductions for our annual income. So a fixed cap would be okay if it was large enough (say 100k). But a “progressive” cap would probably not be enough for folks like us who have unusually high deductions; in this case so that we can give that child the opportunity to ultimately move higher than us in income status.