Americans won't give up tax breaks? Bribe them!

Offering temporary tax breaks to cut down permanent ones could be a way to 'bribe' taxpayers to give up tax breaks.

Sensible budget wonks of all political stripes understand that a solution to our looming budget crisis will require more tax revenues. The aging of the baby boomers and rising health care costs will push up government spending. Yes, I know that we have to slow the growth of health spending and we definitely should look for wasteful or ineffective programs to cut, but spending will go up.

Of course, not a single House Republican is willing to publicly acknowledge this obvious fact. They’re all in the thrall of Grover Norquist’s no-tax pledge, which Lori Montgomery reported he dreamed up as a 14-year-old boy. Fact is, most of the ideas that pop into the adolescent male mind would be a poor guide for public policy and none more so than “the pledge.” Then again, male politicians of both parties seem particularly prone to adolescent behavior. (But there are 24 Republican women in the House. Surely, they’re immune to male adolescent fantasies…)

But I digress.

As Lori discusses, at least in the Senate, some Republicans are open to the idea of cutting “tax expenditures” – the tax credits and deductions designed to subsidize particular activities. In fact, just yesterday, the senate, including most Republicans, repudiated Grover by voting to end ethanol tax breaks. It’s a small step, but suggests that perhaps the dark lord’s death grip on sensible budget policy is weakening.

Cutting tax expenditures is appealing because revenue would rise without requiring higher tax rates. Conservative economist Marty Feldstein has proposed limiting the value of tax expenditures to 2 percent of income. Since the value of tax breaks tends to rise with income, the proposal would be progressive. And it would raise a lot of revenue. Feldstein estimated that a fairly comprehensive cap could cut the deficit by almost half over time.

The obvious problem with cutting tax expenditures is that people like their tax breaks. They include popular items like the mortgage interest deduction, tax-free health insurance, and the charity deduction.

Another problem is that even if voters could somehow be convinced to support big cuts, raising taxes (or cutting spending) significantly right now could thrust the fragile economy back into recession.

There may be a solution to both challenges. We know that Americans are impatient. Why not bribe them to give up their tax breaks? For example, suppose that individual income tax breaks are worth about 10% of adjusted gross income. (This is probably not a bad approximation, but I haven’t crunched the numbers.) It’s unrealistic to assume that all could be eliminated, but we might be able to cut the cost of tax expenditures by half. (See the Bipartisan Policy Center plan, which I helped craft, as an example of how to do this.)

We could phase in a version of Feldstein’s plan by offering a “tax break credit” of 10% of AGI for tax year 2011 in exchange for eliminating tax breaks worth 5% of income. The credit rate could be phased down to 2% of AGI over 5 years. For the first three years, this would be a tax cut compared with current law and provide a needed economic stimulus . To make the stimulus even more effective and help those most in need of aid, the first $5,000 for joint filers could be made refundable ($2,500 for single returns). That amount could also be phased down over time. This would raise taxpayers’ incomes by roughly half a trillion dollars in 2011, and smaller amounts in 2012 and 2013, providing a helpful prod to the economic recovery.

The bottom line is that this plan would boost the economy in the short term, substantially reduce the deficit over the long term with tax rates, and significantly simplify the tax system.

Since I’m a tax geek, I want to get into some technical stuff below. Non-geeks can stop reading now.

Unlike Feldstein’s plan, which caps tax breaks at 2% of AGI, a simpler approach would be to simply deem tax breaks equal to that amount. Set a floor on the credit equal to 15% of the standard deduction and then the standard deduction can be eliminated also. (In Feldstein’s plan, taxpayers have to decide whether to take the standard deduction or itemize subject to the AGI cap.) In addition, the AMT should be eliminated. It wouldn’t cost much if major “preference items” like the state and local deduction were also eliminated.

Some provisions would have to be phased in. For example, part of the plan should be to cap or eliminate the tax exclusion for employer-sponsored health insurance. There’s a near consensus that this exclusion is poorly targeted and contributes to rising healthcare costs. However, it wouldn’t be possible to limit the exclusion in 2011 because employers are not required to measure and report the value of health insurance benefits until 2012.

Also, it would be unfair to prevent taxpayers from taking tax breaks they had counted on this year. Thus, they should be allowed to elect to claim all of their tax breaks in 2011 in lieu of the credit. Most taxpayers would not make this election, but this transition rule is probable necessary.

An earlier version of this post was originally published on my Forbes blog.

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