Harvard’s Feldstein: Capping Deductions Best Tool to Avoid Fiscal Cliff

Thursday, 13 Dec 2012 01:27 PM

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Capping tax deductions — and not slapping tax hikes on top U.S. earners — would serve as the best way to avoid the fiscal cliff, said Harvard economist Martin Feldstein.

The White House and Congressional Republicans are negotiating ways to avoid the fiscal cliff, a combination of tax hikes and spending cuts due to take effect next year that could push the country into a recession if policymakers fail to push through fiscal reforms.

President Barack Obama and his Democratic allies in Congress have insisted any deal must include tax hikes on top U.S. earners, and some have threatened to allow the country to careen over the fiscal cliff if they don’t get what they want.

Editor's Note: Prophetic Economist Warns: “It’s Curtains for America.” See Evidence.

Republicans appear to be warming up to certain tax hikes in exchange for spending cuts elsewhere, though a better proposal would focus more on capping the amount in deductions all taxpayers can take in order to raise revenue.

The limit would not apply to the size of deductions and exclusions, but rather to the resulting tax benefit to each individual.

“Each taxpayer would retain all of his or her existing deductions and exclusions, but the overall cap would limit the total amount by which the taxpayer could reduce his or her tax liability,” Feldstein wrote in a Foreign Policy column.

“A cap of two percent of each individual’s adjusted gross income — applied to the taxpayer benefits from all itemized deductions and excluding municipal bond interest and the value of employer payments for high-value health insurance — would raise about $150 billion at the 2013 level of income, or about 1 percent of GDP [gross domestic product].”

Calls to raise taxes would crimp growth and offset the benefits additional government revenue would bring, something the country cannot afford.

“The wrong way to get that extra revenue is to go over the fiscal cliff, which would cause tax rates on personal earnings, dividends, capital gains and corporations to rise,” Feldstein wrote.

“When combined with the mandatory spending sequester scheduled to be implemented in 2013, demand next year could fall by a total of $600 billion — about 4 percent of GDP — and by larger sums after that. The Congressional Budget Office rightly predicts that would push the economy into a new recession.”

Even an orchestrated approach to raising taxes championed by the White House would cool the economy.

“Obama’s proposed alternative to the fiscal cliff would also substantially raise tax rates and limit tax deductions for the top 2 percent of earners, a group that already pays more than 45 percent of all personal income taxes,” Feldstein noted. “In addition, his budget would increase taxes on corporations.”

Demand would suffer as a consequence.

“And the higher marginal tax rates would reduce incentives to work and invest, further hurting economic activity. All of that could be fateful for an economy that is struggling to sustain a growth rate of less than 2 percent.”

Most Americans want a compromise to avoid the fiscal cliff, even if it means raising taxes, and some business leaders are urging the White House and lawmakers to cut a deal now and end agonizing uncertainty, which can cool growth itself by prompting businesses to hold off on investing in new projects and hiring.

“We are one decision away from restoring our fiscal and moral authority from around the world,” said JPMorgan Chase CEO Jamie Dimon, according to CNBC.

“Let’s just do it.”

The financial community is expecting taxes to rise but hopes spending cuts come hand in hand to ensure more lasting fiscal reform.

“Businesses want a rational deal because most people think it would be great for the United States of America,” said Dimon, who insisted that tax increases be “linked inexorably together with rational entitlement reform,” CNBC added.

Editor's Note: Prophetic Economist Warns: “It’s Curtains for America.” See Evidence.

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