The Tax Math of the Fiscal Cliff Discussion

In a blog post on the White House's website, National Economic Council Director Gene Sperling and Deputy Director Jason Furman argue that the math of limiting deductions for high-earners dictates that an insufficient amount of revenue will be raised. They take a $25,000 cap on itemized deductions (which would raise $1.3 trillion over ten years), apply it only to people making more than $250,000 (40 percent revenue reduction), phase it in to prevent a huge tax increase as people cross the $250K threshold (additional 20 percent revenue reduction), and take out the charitable deduction (additional 30 percent revenue reduction). What's left is only $450 billion of revenue, or slightly less than half of the upper-income tax cuts. As a result, they conclude:

Plausible tax expenditure limitations that protect middle-class families and incentives to give to charity would raise far less revenue from the well off than is needed for a major budget agreement. A budget framework that raises only these amounts from high-income tax deductions while committing to no rate increases on high-income Americans would inevitably force any tax reform designed to further reduce the deficit to raise taxes on middle-class families simply to preserve lower rates for the most fortunate.

Revenue from $25,000 Cap
  Ten-Year Revenue
Impose $25,000 Cap on Itemized Deductions $1,300
Exempt People Below $200,000/$250,000 -$500
Phase In Cap -$150
Exempt Charitable Deduction -$200
Final Deduction Cap $450

Source: White House

They make a good point that making these modifications will reduce the revenue available. However, a comprehensive examination of the options shows that this conclusion is much too dismissive.

First of all, any of these tax expenditure limitations is dialable. One can change the limit, the tax expenditures, or other parameters to meet the desired revenue target. Also, the income level at which it applies could not be indexed for inflation. As an easy example, the White House numbers assume the $250,000 threshold is indexed to inflation, but it could be held flat in nominal dollar terms as is the case for the Medicare surtax in the Affordable Care Act.

Second, the $25,000 cap is only one of many options to limit tax expenditures and indeed it is the smallest of the options we outlined recently, in large part because it only looks at itemized deductions and ignores other tax expenditures. We outlined two other types of limitations in a recent paper, both of which would raise more revenue than the $25,000 cap. These included:

  • A Feldstein-Feenberg-MacGuineas style cap, which would cap tax expenditures at two percent of income. It would likely bring in more revenue than the $25,000 cap, especially if additional tax expenditures were included.
  • The President's preferred policy of capping the value of itemized deductions and certain other deductions and exclusions at 28 percent. The policy was modified so the value phases down to zero for people making over $1 million.

Dealing with the charitable deduction need not be a binary choice of include or exempt. We previously discussed ways in which the charitable deduction could be limited to raise revenue while mitigating the impact on charitable giving. These options include converting the deduction into a credit, having a credit for deductions that exceed a cap, or in the case of the 28 percent limitation, not phasing down the charitable deduction to zero. One could also convert the charitable deduction to an above-the-line deduction, as opposed to an itemized deduction, with a floor which contributions must exceed to be deductible. All of these methods still raise revenue from the charitable deduction while maintaining a marginal incentive to contribute to charities.

Finally and perhaps most importantly, any limitation of deductions and other tax expenditures can and should be combined with other policies. The $950 billion in upper-income tax cut expirations comes not from one policy, but from six different ones. Expecting to finance them all with a single policy might be asking too much. Any across-the-board limitation could be combined with any number of discrete policy changes, including the potential expiration of some of the upper-income tax cuts.

The White House did an important service by showing that these broad-based limitations are no silver bullet for reforming tax expenditures. Every policy has advantages and disadvantages, and there are no easy ways to generate substantial deficit reduction, particularly when focusing on such a small portion of the population. But that policies are hard does not make them impossible, and that they may be smaller than they look at first glance does not mean they are not worth pursuing.