Harvard’s Feldstein: Cap Deductions to Tackle the Fiscal Cliff

Monday, 03 Dec 2012 11:41 AM

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Lawmakers and the White House should focus on capping tax deductions and broadening the tax base during their discussions on how to steer the economy away from the fast-approaching fiscal cliff, said Harvard economist Martin Feldstein.

At the end of this year, tax breaks are set to expire at the same time automatic spending cuts are due to kick in, a combination known as a fiscal cliff that could send the country into a recession next year if left unaddressed by Congress and the White House.

One sticking point lies in taxes, with Democrats pushing for keeping tax breaks in place except for households bringing in $250,000 or more, a move Republicans — and Feldstein — oppose.

Editor's Note: The ‘Unthinkable’ Could Happen — Wall Street Journal. Prepare for Meltdown

A solution involving capping deductions without raising rates would bring in government revenue and fuel growth down the road.

“President Barack Obama’s proposed alternative to the fiscal cliff would substantially increase tax rates and limit tax deductions for the top 2 percent of earners, who now pay more than 45 percent of total federal personal-income taxes. His budget would also increase taxes on corporations, and would end the current payroll-tax ‘holiday,’ imposing an additional 2 percent tax on all wage earners,” Feldstein writes in a Project Syndicate column.

“Together, these changes could lower total demand by nearly 2 percent of GDP [gross domestic product]. And the higher marginal tax rates would reduce incentives to work and to invest, further impeding economic activity,” he added.

“All of that could be fateful for an economy that is still struggling to sustain a growth rate of less than 2 percent.”

A better alternative, Feldstein writes, would involve a gradual phase in of caps to deductions and broadening the tax base over time.

“The potential recession risk of a budget deal can be avoided by phasing in the base-broadening that is used to raise revenue. A desirable way to broaden the tax base would be to put an overall cap on the amount of tax reduction that each taxpayer can achieve through deductions and exclusions,” Feldstein pointed out.

“Such an overall cap would allow each taxpayer to retain all of his existing deductions and exclusions but would limit the amount by which he could reduce his tax liability in this way.”

Capping deductions would also steer taxpayers from itemizing deductions to make more standard deductions, which would simplify recordkeeping. In fact, capping tax reductions derived from expenditures equal to 2 percent of every individual’s adjusted gross income would raise more than $200 billion in 2013, Feldstein wrote.

When pushed through alongside reforms to entitlement programs like Social Security and Medicare, capping deductions could put the country back on the path to economic health.

“America’s national debt has more than doubled in the past five years, and is set to rise to more than 100 percent of GDP over the next decade unless changes in spending and taxes are implemented,” he noted.

“A well-designed combination of caps to limit tax expenditures and a gradual slowing of growth in outlays for entitlement programs could reverse the rise in the debt and strengthen the U.S. economy.”

Treasury Secretary Timothy Geithner has remained firm on the White House’s position that any deal averting the country from the fiscal cliff must involve allowing the Bush-era tax cuts for households bringing in over $250,000 a year to expire.

“There’s not going to be an agreement without rates going up,” Geithner told CNN, adding refusal on the part of Republicans will bruise the economy.

“If they are going to force higher rates on virtually all Americans because they’re unwilling to let tax rates go up on 2 percent of Americans, then, I mean that’s the choice they’re going to have to make.”

Editor's Note: The ‘Unthinkable’ Could Happen — Wall Street Journal. Prepare for Meltdown

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