Tax Reform Needed for Deficit Reduction

The federal government can find more revenue by limiting a whole range of deductions

All across the political spectrum, everyone's agreed the federal government can't continue piling up trillion-dollar budget deficits that are driving up the nation's debt to more than its gross domestic product.

Yet there's a fundamental divide in Congress over what to do about it. With virtual unanimity, Republicans insist the nation's got a spending problem and that the sole path to deficit reduction is to cut expenditures. President Obama and Democrat leaders, on the other hand, insist that revenue increases are an important part of the solution, and that means raising taxes.

For all the disagreement, though, there's broad bipartisan consensus on curtailing an estimated $1.1 trillion annual revenue drain in the form of what are known as tax expenditures. These backdoor outlays encompass the benefits of a myriad of federal income tax exclusions, credits, and deductions that contribute just as much to the deficit as if they were appropriated.

The two largest—exclusion from taxable income of employer health insurance premiums and contributions to retirement accounts—are probably untouchable for now. But the three biggest tax deductions—for home mortgage interest expense, state and local taxes, and charitable contributions—carry an estimated annual cost of around $200 billion. And while hardly anyone is proposing their elimination, it's clear they could be made much more equitable at much lower cost.

In a recent op-ed piece in The New York Times, Martin Feldstein, who was Chairman of the Council of Economic Advisors under President Ronald Reagan, wrote that, "reducing the budget deficit and stopping the explosion of our national debt will require more tax revenue as well as reduced government spending. But the need for more revenue needn't mean higher tax rates. As the bipartisan fiscal commission appointed by President Obama stressed last year, tax revenues can be increased substantially by limiting the deductions, credits, and exclusions that are essentially government spending by another name."

Indeed, a commission majority that included two Republican and two Democratic senators went further in recommending that cuts in tax expenditures be coupled with a reduction in individual income tax rates from 35 percent to 28 percent in the top bracket with commensurate reduction in lower brackets.

In lieu of tax deductions, the majority recommended a 12 percent tax credit for residential mortgage interest (subject to a $500,000 maximum loan amount) and for charitable contributions in excess of 2 percent of taxpayer income. State and local tax payments would no longer get a tax break, but that break is already denied to most wealthy individuals due to the convoluted workings of the Alternative Minimum Tax, which is a trap for the unwary that the commission majority would rescind.

What makes a tax credit more equitable than a tax deduction is that it uniformly benefits all eligible taxpayers regardless of their income. By contrast, a deduction of any given amount is worth more than twice as much in savings to someone with high income in the 35 percent tax bracket than to someone in the 15 percent tax bracket.

In a paper published by the Progressive Policy Institute, Paul Weinstein Jr., who served as senior advisor to the commission, estimates that its tax expenditure plan, which includes curbing other tax breaks, would raise $80 billion a year in revenues by 2015. Unfortunately that's $80 billion more than most Republicans who support tax expenditure reform are prepared to accept as matters stand.

Sen. Bob Corker typifies their stance when he said in a WBIR-TV interview, "We've got $1.2 trillion in tax expenditures and if you want to talk about doing away with most of those and lowering everyone's tax note to end up with the same revenues, then sign me up." Given the prevalence of such sentiments, Congress should start working now on tax reform, which entails enormous complexities, and defer a decision on how much should go toward raising revenues and how much to rate reduction. But the House Ways and Means Committee, which would have to initiate any such legislation, hasn't begun to do so.

Corker, for his part, is in the forefront of lawmakers seeking to solve the nation's fiscal crisis purely by cutting spending. He has garnered a modicum of bipartisan support for a bill he's sponsoring that would impose a cap on federal outlays that would steadily decline from 24.6 percent of GDP in the current fiscal year to 20.6 of GDP 10 years out. The latter figure he points out, represents the average over the past 40 years, and a 10-year path toward restoring it might seem ample.

The fallacy in Corker's plan is that the past is not necessarily indicative of the future. As the Congressional Budget Office warns in a recent publication, "over the longer term, the continued aging of the population and growth in health-care costs will almost certainly push up federal spending relative to GDP under current law."

Spiraling costs of Medicare are the biggest single factor. Yet many Republicans are now distancing themselves from the proposal by the Chairman of the House Budget Committee to rein in Medicare costs by converting it into a voucher system that would only pay a set amount for coverage. "I don't think there's anybody in this room that would say it's an article of faith," Corker observed after a Senate vote on it last week.

Curbing tax expenditures certainly aren't a total solution to the nation's humongous deficit/debt problem, but they can be a big part of it.