The real lesson about capping itemized deductions

The Tax Policy Center is back in the political cauldron, this time in the wake of its new research that looks at the revenue and distributional effects of caps on itemized deductions.

TPC’s aim was to analyze an interesting idea that could find its way into future tax reform plans. Its conclusion was a mix of good and bad news. The good: Such a cap is a highly progressive way to raise substantial revenues. The bad: Even eliminating all itemized deductions cannot raise enough money to pay for a tax reform that significantly cuts rates without adding to the budget deficit.  

But, alas, we are in the midst of a contentious political season. And because Mitt Romney has at least three times in the past few weeks raised the possibility of such a deduction cap, his campaign has gotten defensive about TPC’s results, accusing the center of, among other things, being “misleading and deceitful.”

This is, to say the least, odd, since TPC’s findings provide evidence that a deduction cap is a pretty good, though insufficient, idea.   

Let’s all take a deep breath here. TPC did not try to analyze Romney’s plan (since he won’t tell anybody what it is, we can hardly model it). Rather, our analysis applies far more broadly to any tax reform. And the real message is this: Doing reform that significantly reduces rates without adding to the budget deficit requires lawmakers to curb more than itemized deductions. If you want to substantially reduce rates, going after popular tax breaks such as deductions for mortgage interest, charitable gifts, and state and local taxes, is only the beginning.

Reformers also have to look at other tax preferences that are ingrained in economic behavior, such as the exclusions for employer-sponsored health insurance and municipal bond interest, tax subsidies for retirement savings, and the low rates on capital gains and dividends.

This is hardly an earth-shattering insight. After all, it is what the chairs of President Obama’s fiscal commission, Erskine Bowles and Alan Simpson, did in 2010. It is also what the Bipartisan Policy Center’s fiscal tax force, chaired by former GOP senator Pete Domenici and former Clinton budget director Alice Rivlin, concluded two years ago. TPC has been telling the same story through a series of research papers since last summer.

Here’s where things get complicated for reformers. A cap on deductions has three big advantages. It is a very progressive way to raise new revenues. It is administratively relatively simple (through not without its problems). And it is politically attractive since it avoids having to tackle individual tax preferences—each with its own powerful constituency—one at a time.

But if the deduction limit doesn’t raise enough money, lawmakers would have to reach into other tax preferences to pay for big rate reductions. And many of them, such as the exclusion for employer-sponsored health insurance and tax incentives for retirement savings, disproportionately benefit the middle-class.

Curbing them would make it much harder to maintain progressivity than just capping deductions does. A cap on exclusions is lots more complicated. In addition, curbing middle-class savings incentives at least may not be the smartest long-term economic policy.  

That brings us to tax preferences for capital gains. Raising the rate on gains could generate substantial revenue in a very progressive way. Indeed, both Bowles-Simpson and Rivlin-Domenici chose to tax gains at ordinary income rates (though those rates were substantially lower than today rates).

And that, in the end, may be the real story here. Lawmakers may find that the road to substantially cutting rates without adding to the deficit may inevitably lead through the capital gains tax. If they don’t want to mess with capital gains, they may have no choice but to scale back their ambitions when it comes to rate reductions. And that applies whether you are Mitt Romney or anybody else.