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Obama’s Good Tax Proposal

Tuesday, October 18, 2011

One White House proposal deserves to be considered by policy makers in both parties who are looking for ways to improve the tax code.

Last month, President Obama put forward a re-tooled version of his longstanding proposal to limit tax preferences for high-income households, presenting it as a way to help pay for his jobs plan. Although his proposal is not perfect, it deserves serious consideration as a way to narrow some of the economic distortions created by today’s tax code.

At incomes above $200,000 ($250,000 for couples), the president’s proposal would limit the tax savings from certain tax deductions and exclusions to 28 percent of the deducted or excluded amount. Under the current tax system, the percentage savings can be higher, depending on the taxpayer’s bracket. For example, a taxpayer in the 35 percent top bracket now saves $35,000 on her taxes by claiming $100,000 of itemized deductions, as she has $100,000 less taxable income on which to pay the 35 percent tax. The proposal would limit her tax savings to $28,000, effectively taking back one-fifth of the deductions.

The original version of the proposal would have limited only the tax savings from itemized deductions, such as mortgage interest, state and local taxes, and charitable contributions. Last month, though, President Obama moved away from this artificially narrow focus by expanding the proposal to cover the tax exclusions for employer-provided health insurance and municipal bond interest.

Limits on tax preferences have one key advantage over rate hikes—they curb the distortions produced by the tax code.

One thing hasn’t changed—the proposal is still restricted to the richest 2 or 3 percent of the population. President Obama’s exclusive focus on taxing that group can be questioned on a number of grounds. Still, the ultimate resolution of the fiscal imbalance is likely to include some kind of high-income tax increase. It’s imperative that any such tax increase be designed in a way that does as little economic damage as possible. By that standard, it’s better to limit tax preferences, as this proposal does, than to hike official tax rates.

That’s not because limiting tax preferences does less to impair incentives to work and save—far from it. Because a portion of each additional dollar earned from work or saving is spent on tax-preferred items, limiting the tax savings on those items increases the net tax on earning the dollar, just as an explicit tax rate hike would do.

But limits on tax preferences do have one key advantage over rate hikes—they curb the distortions produced by the tax code. The preferences built into today’s tax system tilt the economic playing field, giving people artificial incentives to change their behavior. For example, the tax system rewards people for receiving employer-provided health insurance rather than cash wages and for investing in owner-occupied homes rather than in business capital. Just like government spending programs, these provisions divert economic resources away from where market forces would direct them. The president’s proposal would reduce a wide range of these distortions in one fell swoop.

It’s imperative that any tax increase be designed in a way that does as little economic damage as possible. By that standard, it’s better to limit tax preferences than to hike official tax rates.

And because of the way tax preferences work, the proposal’s focus on high-income households actually makes sense. These preferences give the biggest percentage savings to those in the top brackets, the very taxpayers for whom the provisions are least likely to promote valid social goals. It may be good tax policy to encourage low-paid workers to get health insurance, but it’s not good tax policy to move high-paid workers into Cadillac health plans that help drive up medical costs. Maybe the tax system should encourage moderate-income families to become homeowners, but it shouldn’t encourage high-income homeowners to buy bigger and more expensive houses. Yet, the current tax breaks for insurance and housing give the biggest percentage incentives to those at the top, simply because they are in the highest brackets. A 28 percent cap on the tax savings in those brackets is one way to target the biggest and least defensible distortions.

The proposal is hardly perfect. Some transitional issues may need to be worked out and further changes to the list of covered tax preferences may be desirable. The proposal does not go as far as it might—some reform plans take the bolder step of transforming deductions and exclusions into tax credits that provide uniform savings of 12 or 15 percent in all brackets. And, the proposal does nothing to move the tax system toward consumption taxation. Also, at this point, President Obama appears to view limits on tax preferences as a companion to tax rate increases rather than as a substitute for them, although he has alluded to the possibility of rate-reducing tax reform down the road.

Despite its flaws, the president’s proposal would limit the tax system’s interference in the economy. It deserves to be considered by policy makers in both parties who are looking for ways to improve the tax code.

Alan D. Viard is a resident scholar at the American Enterprise Institute.

FURTHER READING: Viard also writes “The Chained CPI: A Path to Bipartisan Deficit Reduction,” “Do Taxes Narrow the Wealth Gap?” “A Debt Opportunity Deferred, Not Entirely Lost,” and “Should Groceries Be Exempt from Sales Tax?

Image by Rob Green | Bergman Group

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