All tax increases are not created equal

Reuters

Speaker of the House John Boehner (R-OH) answers a question at a news conference on Capitol Hill in Washington, November 9, 2012.

Article Highlights

  • There’s a 2nd way to raise taxes: go after deductions themselves. This can have an entirely different economic impact.

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  • The basic problem is this: Republicans see tax deductions as tax cuts, while Democrats see them as spending.

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  • We didn't get into this fiscal fix as a result of thinking straight, & we won't get out of it unless both sides wise up.

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In a speech immediately following the election, House Speaker John Boehner offered President Obama an olive branch on taxes: Republicans are open to raising more taxes to help close the budget deficit, Boehner said, but it must be through tax reform rather than raising tax rates. "Tax reform" is almost certainly a euphemism for broadening the tax base by eliminating deductions, which leave trillions of dollars in income untaxed. Is this a deal in the making? Perhaps. If you have to raise taxes, this may be the way to do it. But both Democratic and Republican mindsets stand in the way.

Most conservatives and Republicans oppose raising tax rates because of their negative effects on individual incentives and the economy. Economists call this a "substitution effect"-that is, raising marginal tax rates induces individuals to substitute working with leisure time. If the government is taking a greater share of each additional dollar you earn, many people will simply choose to spend more time with their family, on the golf course, or whatever. And even those people who continue to work will make greater efforts to hide their income from taxation, in particular by exploiting tax deductions. Economists argue over how large these effects are, but no one claims that raising marginal tax rates won't hurt the economy.

But there's a second way to raise taxes: go after the deductions themselves. This can have an entirely different economic impact. For instance, a person might be able to deduct less of their mortgage interest, raising the amount they pay to the government. This has what economists call an "income effect" — people would have less after-tax income, and on average people would work more in order to make up the loss. But the amount they pay on each additional dollar of earnings — their marginal tax rate — stays the same, meaning that the tax change hasn't created any disincentive for them to decrease their work effort. While raising marginal rates would likely hurt economic growth, reducing tax deductions would likely increase it, at least by a modest amount.

This approach becomes even more compelling when we consider what our tax deductions actually "buy." For instance, the mortgage interest deduction has encouraged Americans to buy bigger houses, but it hasn't given America a much higher home ownership rate than other countries that lack such a perk. Similarly, the deduction for employer-sponsored health coverage has been a prime suspect in why the U.S. spends so much more on health care than other developed countries. Given the housing bubble and rising health costs, once could argue for limiting these deductions even if budget problems weren't so pressing.

Moreover, due to the progressivity of the income tax code, the lion's share of the benefits from tax deductions flows to the wealthy. For example, the Urban-Brookings Tax Policy Center has reported that capping itemized deductions at $50,000 would raise nearly $750 billion in revenue over 10 years. Ninety-six percent of the new taxes would come from the top 20 percent of taxpayers and 79 percent would come from the top 1 percent. Surely this would warm the hearts of President Obama and his supporters.

So what's not to like? The basic problem is this: Republicans see tax deductions as tax cuts, while Democrats see them as spending. Many Congressional Republicans have signed pledges with tax advocacy groups not to reduce tax deductions without other offsetting tax cuts. So no matter how wasteful these deductions are, we can't cut them in order to reduce the budget deficit. On the Democratic side, the major tax deductions are often referred to as "tax expenditures" - that is, spending through the tax code. Deductions for home mortgage interest or health coverage could just as easily be accomplished through direct federal spending as tax write-offs. But framing them as tax cuts avoids the political pitfalls of raising spending. So Democrats resist as well.

And there's the rub: Republicans are so averse to raising taxes that they won't do it even if what they're really doing is cutting spending. And Democrats are so wedded to spending that they can't cut it, even when we face a budget crisis and that spending disproportionately benefits the very rich. But we didn't get into the fiscal fix we're in as a result of people thinking straight, and we won't get out of it unless both sides wise up.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute. He previously served as principal deputy commissioner of the Social Security Administration.

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