Tax Analysts Blog

The Hidden Economic Damage of Deduction Caps

Posted on Nov 15, 2012

Prominent Democrats like former Clinton Treasury Secretary Robert Rubin and current New York Senator Charles Schumer are all reading from the same talking points: They are asserting that without rate hikes on the wealthy it is not possible to raise enough revenue--we're talking in the neighborhood of $1 trillion over 10 years--without raising taxes on the middle class. They say the wealthy simply do not have enough tax breaks that can be eliminated to raise that type of revenue.

It is not a bad thing that they are tamping down expectations. It is probably politically impossible to sufficiently cut tax breaks on the wealthy (think about the reaction of charities to the idea of their biggest donors losing tax benefits for giving). But it is mathematically possible Calculations by the Tax Policy Center suggest that eliminating all non-saving tax expenditures for those with incomes over $200,000 would raise more than $160 billion per year--more than enough to satisfy even Obama's opening bid.

The big unrecognized problem with a Romney-style deduction cap--or other similar proposals like the Feldstein 2% of AGI tax benefit cap, the Obama 28-percent limit on the value of deductions and exclusions, and the Pease phase-out of itemized deductions, is that they substitute explicit tax rate increases for hidden marginal rate increases. Marginal rates are hard to calculate and hidden from the public but whether they are hidden or advertised they are the critical features of the tax system that matter for work effort and job creation.

How do these caps raise marginal tax rates? They all work in different ways (with significant difference in the distribution of the tax burden as well as distribution of incentives). Let's just discuss one example (although similar effects can be found for all these caps). For affected taxpayers the Romney cap would shift the statutory rate structure down the income scale. That is to say, as you move up the income scale taxpayers with lower incomes would feel the effects of progressively higher rates sooner. The effect on marginal rates would not be uniform. Taxpayers just below the breakpoints between rates would be pushed into higher brackets and be subject to large marginal rate changes. Meanwhile taxpayers significantly below breakpoints would not be pushed into higher brackets and would have no marginal rate change.Taxpayers just below the breakpoints between rates would be pushed into higher brackets and be subject to large marginal rate changes.

Confused? Well, it is hard to understand. But that does not make it less real. The bottom line: deduction caps are backdoor marginal rate increases with economic effects just as harmful as any explicit rate increase. When you consider the added complexity caps would create it would be better to simply raise rates.

Read Comments (1)

AMT buffNov 19, 2012

deduction caps are backdoor marginal rate increases with economic effects
just as harmful as any explicit rate increase. When you consider the added
complexity caps would create it would be better to simply raise rates.

Better economically, but harder politically. Politicians only care about the
latter. Isn't that obvious by now?

Marginal rates are already quite a bit higher than people realize, as explained
in a new CBO report: http://www.cbo.gov/publication/43709

Congress will never enact a tax law which reveals today's true marginal rates
to the public, let alone the higher rates which are coming. Hidden marginal
rates are here to stay.

Dishonest taxation will get much worse before it gets better. Improvement can
only happen when the public stops believing in any advertised (statutory) rate.
Then Congress may wipe the slate clean of hidden rates, only to begin the
process anew.

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