Options for Limiting Tax Expenditures

Update: Howard Gleckman of Tax Policy Center has blogged on their paper over at TaxVox.

With the chaos of the debt ceiling now over, it's time to take a calm, relaxed look at some of the policies that the "special committee" or other future deficit-reduction efforts can use. Today, we will look at a new paper from the Tax Policy Center that examines a few options for limiting tax expenditures for high-income earners.

The three policies that TPC uses in their analysis are the Obama Administration's proposed limitation on itemized deductions, a new "effective minimum tax", and a percentage of income limitation on tax expenditures. All of these policies would raise significant amounts of revenue relative to either a current law (tax cuts expired) or current policy (tax cuts extended) baseline. Additionaly, the impact of these policies would be almost completely confined to the top quintile of taxpayers--and especially the top five percent.

The first policy is one that President Obama has proposed in each of his three budget proposals: limiting itemized deductions to 28 percent. Since taxpayers in the two brackets would face rates of either 33 percent and 35 percent (current policy) or 36 percent and 39.6 percent (current law), they would have the value of their deductions reduced by the difference between those rates and 28 percent. While the Administration's intent was to use this to raise taxes only on people making over $250,000, people making over roughly $215,000 would be affected under current law or current policy.

The second policy would create a new effective minimum tax whose purpose, like the similarly named Alternative Minimum Tax (AMT), would be to ensure that taxpayers pay at least a certain percentage of their income in taxes. These percentages would be 27 and 21 percent under current law and current policy, respectively. The new minimum tax would exempt people making under $250,000 (a much higher exemption than the AMT) and would phase in gradually for income between $250,000 and $500,000. As a side note, TPC made the rates 27 and 21 percent so that the minimum tax would raise a similar amount of revenue to the itemized deduction limitation.

The final policy TPC looked at is a two percent of income limitation on tax expenditures, a variant on an earlier proposal by CRFB President Maya MacGuineas, former CEA chair Martin Feldstein, and NBER economist Daniel Feenberg. The difference is that this limitation would only apply to people making over $250,000, phasing in gradually for income above that amount. Although this proposal would affect fewer taxpayers, it would hit people at the top more than the other policies and would raise more than twice as much revenue relative to current law.

The table below sums up the revenue impact of all three policies under both baselines.

Revenue Impact of Limiting Tax Expenditures (billions)
Policy Current Law (2012-2021) Current Policy (2012-2021)
28 Percent Limitation $288 $164
Effective Minimum Tax $258 $169
Two Percent Limitation $592 $520

We have also reproduced TPC's current policy distributional analysis below. As you can see, the two percent of AGI limitation on tax expenditures is the most progressive, followed by the minimum tax and then the 28 percent limitation.

Percent Change in Income Under Each Policy
Income Group 28 Percent Limitation Effective Minimum Tax Two Percent Limitation
Lowest Quintile 0.0% 0.0% 0.0%
Second Quintile 0.0% 0.0% 0.0%
Middle Quintile 0.0% 0.0% 0.0%
Fourth Quintile 0.0% 0.0% 0.0%
80-90 Percent 0.0% 0.0% 0.0%
90-95 Percent -0.1% 0.0% 0.0%
95-99 Percent -0.4% -0.2% -0.6%
Top 1 Percent -0.6% -1.8% -2.6%
Top 0.1 Percent -0.8% -2.4% -3.2%

As a matter of preference, we would prefer to see a comprehensive tax reform approach that raises revenue. However, if doing so proves to be too difficult politically, these across-the-board tax expenditure cuts are another way to go. The limitations reduce the distortions that tax expenditures cause and make the tax code more progressive, while raising the revenue we need to reduce our deficits and debt.

PS: Click here to read our Let's Get Specific paper on tax expenditures.