Deficit Crisis Threatens Once-Untouchable Tax Breaks

Itemized deductions, including for some home mortgage interest, could disappear in tax-code rollbacks.

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In the effort to cut the federal budget deficit, reforming the tax code seems to be an area of common ground among Democrats and Republicans. Reducing or eliminating long-cherished tax breaks would undoubtedly trigger major clashes among affected consumers, companies, and advocacy groups. The fact that such battles may be waged anyway is a telling sign of how serious the deficits have become, and how difficult it is to reach agreement on other solutions to the problem.

In the simplest terms, Democrats are seeking ways to reduce budget deficits without threatening Medicare, Medicaid, and Social Security—programs of vital interest to retirees. They believe raising taxes must be part of the solution. Republicans are seeking ways to reduce deficits without raising taxes, and they're more open to entitlement cuts to achieve their goals.

[See 10 Essential Sources of Retirement Income.]

The public, it should be stressed, is against both entitlement cuts and higher taxes. Politicians of both parties have been reluctant to risk public wrath over the unpleasant medicine that virtually every economist and budget expert feels will be necessary to begin correcting the country's ruinous debt accumulation.

One way around the impasse may be found in federal tax breaks—technically called tax expenditure items. These benefits have been written into the tax code over decades and now total more than $1 trillion a year in reduced federal tax revenues. That's a big number, even stacked up against our current national debt of more than $14 trillion.

By attacking some of these tax breaks, Democrats could find some protective ground against entitlement cuts. Likewise, reduced tax breaks would permit Republicans to achieve lower individual and corporate tax rates—technically honoring their pledge not to raise taxes—while allowing revenues to increase and help close the budget gap.

"You can't do it piecemeal. It's got to be a bundled approach," says Ted Gayer, a public finance and tax expert at the Brookings Institution, the prominent liberal think tank in Washington. "A lot of the big ones wouldn't be completely dropped, but would be reduced." One possible sticking point for Republicans opposed to tax increases, he noted, is whether higher revenues from cutting tax expenditures would be viewed as a tax increase.

Last December, President Obama's National Commission on Fiscal Responsibility and Reform included extensive recommended changes to the tax code in its final report, "The Moment of Truth." The commission's report was not supported by enough members to trigger Congressional action. But its work is regularly cited as the most advanced starting place for any serious deficit-cutting effort.

[See Why Tax Rates are Low but Opposition Is High.]

"Washington has riddled the system with countless tax expenditures, which are simply spending by another name," its report said. "These tax earmarks—amounting to $1.1 trillion a year of spending in the tax code—not only increase the deficit, but cause tax rates to be too high."

If all tax expenditure items were eliminated, the commission said, individual and corporate tax rates could plummet and government would still take in the same amount of revenue. Individual tax rates now range from 10 to 15 percent for low earners, 25 to 28 percent in the middle tier, and 33 to 35 percent for the wealthiest taxpayers. These rates would fall to 8, 14, and 23 percent without the drain of tax expenditures. The corporate tax rate would fall to 26 percent from 35 percent.

The commission did not recommend simply doing away with all expenditure items. Its approach would retain breaks for low-income workers and their families, and would even increase some of them.

It would modify the deduction for mortgage interest. This benefit can now be taken for mortgage interest on two homes, valued at up to $1 million, and up to $100,000 in home equity loans. The commission proposed cutting the upper value limit in half, to $500,000, and eliminating the second home and home equity loans entirely. And instead of allowing the benefit to be taken as a tax deduction, the commission would replace it with a 12 percent non-refundable tax credit. In fact, it would end all itemized deductions and require all individual taxpayers to take the standard deduction.

[See How the Budget Deficit Could Lead to Generational Warfare.]

Other big changes proposed by the commission are to end the low tax rates on capital gains and dividends and tax all such gains as ordinary income. Interest income on newly issued state and municipal bonds would be taxable. Charitable giving would also receive a 12 percent tax credit but only on the portion of such giving that exceeded 2 percent of taxable income. Two other popular tax breaks—allowing employer health insurance and retirement investment accounts to be funded with pre-tax dollars—would be retained but reduced through caps. Most other tax expenditure items would simply disappear.

Another approach was recently advocated by budget experts Martin Feldstein and Maya MacGuineas. It would keep all the tax expenditure items in place. But it would sharply limit their benefits to taxpayers by capping the tax reduction to 2 percent of taxable income. Such an approach could reduce the divisive arguments about which tax breaks should be kept.

"Taxpayers with incomes of $25,000 to $50,000 would pay about $1,000 more in taxes; those with incomes of more than $500,000 might pay $40,000 more," Feldstein wrote in a recent opinion piece in the New York Times. The 2 percent cap would raise government revenues by nearly $280 billion this year and over time, would equal half of the projected future federal deficits, he said. If such a cap was considered too severe, he noted, higher percentage caps could be used to raise less money.

Twitter: @PhilMoeller