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Here's What The 'Fiscal Cliff' Tax Deal Is Starting To Look Like
The Economist | Nov. 18, 2012
Barack Obama and Republicans grope towards common ground on taxes...
THE election dust had barely settled when Barack Obama and his Republican adversaries returned to their traditional rhetoric over taxes. "Raising tax rates is unacceptable," John Boehner, the Speaker of the House of Representatives, declared on November 8th. The next day Mr Obama said "I am not going to ask students and seniors and middle-class families to pay down the entire deficit while people like me, making over $250,000, aren’t asked to pay a dime more in taxes."
Optimists, however, took note of what the men did not say: Mr Boehner did not rule out raising tax revenues. Mr Obama did not explicitly insist that the two top income tax rates, now 33% and 35%, return to 35% and 39.6%, as they are scheduled to do when George W. Bush’s tax cuts expire at the end of this year.
This has aroused hopes that the two men can find common ground on tax reform that leaves marginal tax rates where they are while raising new revenue by curbing credits, deductions and exemptions (collectively called tax expenditures), which distort economic activity. Numerous such proposals have been aired in recent years, some of which Republicans hated because they raised new revenue; others Democrats rejected because they gave a windfall to the wealthy.
One way this could be done is to target deductions that primarily benefit the rich. During the election campaign, Mitt Romney proposed paying for big marginal rate cuts by setting a cap on total deductions. The Tax Policy Centre, a think-tank, reckons a cap of $50,000 would raise $749 billion over ten years, comparable to the $800 billion that Mr Boehner entertained during failed negotiations with Mr Obama in 2011. Importantly, this fix would make the tax system much more progressive: 80% of the additional money would come from the top 1% of earners. This has helped draw interest from some Democrats.
A slightly different proposal by Martin Feldstein, a prominent Republican economist, and Maya MacGuineas of the Committee for a Responsible Federal Budget, a think-tank, would cap the tax benefit of itemised deductions at 2% of income for all households. Mr Feldstein reckons that would raise more than $2 trillion over ten years, although almost all families would pay more tax, not just the rich.
As it happens, Mr Obama has already proposed curbing tax breaks for the wealthy (see table). His budget would restore the limits on their exemptions and deductions that Mr Bush’s tax cuts eliminated. A separate proposal would limit the tax benefit of deductions for mortgage interest, charitable contributions, municipal bond interest, employer-provided health care, and individual retirement plans to 28%, even for taxpayers paying a 35% or 39.6% marginal rate.
Despite their superficial appeal, such proposals face daunting obstacles. Foremost is that they may not raise enough revenue to satisfy Mr Obama. In the run-up to formal negotiations due to begin on November 16th, Mr Obama signalled he would begin by asking for $1.6 trillion in revenue over the coming decade, as his latest budget does. At a press conference on November 14th, he said "it’s very difficult to see how you make up" the revenue lost from failing to restore the higher rates just by closing deductions: "The math tends not to work." But, he added, "I’m not going to just slam the door" on alternatives that accomplish what he wants.
The second obstacle is the calendar. Politicians are racing against a year-end deadline when Mr Bush’s tax cuts and other stimulus measures expire and automatic spending cuts are triggered. The collective fiscal tightening, if sustained, could push the economy into recession. Even if the two sides agreed that tax reform would be the main vehicle for raising more revenue, the task would be too complex to accomplish by year-end. A smaller deal would be needed to avert the cliff, leaving bigger tax and entitlement changes for next year. The challenge then would be to bind the hands of both parties to consummating a big deal next year.
For all the appeal of curbing loopholes, each has vocal and influential defenders. When the Obama administration first proposed its 28% cap on tax expenditures, "we got killed," Peter Orszag, Mr Obama’s first budget director, recalls, in particular by charities and non-profit groups. For Mr Obama and Mr Boehner, finding agreement with each other may very well prove to be the easy part.