We’ve criticized its harsh cuts to many working-poor families and likely adverse long-term fiscal effects, but House Ways and Means Chairman Dave Camp’s tax reform proposal has positive elements as well. One that’s received little attention is its 25 percent cap on the value of most major deductions and exclusions (such as mortgage interest and employer-provided health insurance), which would make the tax code fairer and more economically efficient.
Itemized deductions and exclusions are “upside down.” Their value is tied to the taxpayer’s marginal tax rate, so the higher one’s tax bracket, the greater the tax benefit for each dollar that’s deducted or excluded. Thus, the biggest tax subsidies go to high-income people, who least need them to do whatever the tax break is designed to promote, like buy a house.
For example, a banker making $675,000 receives a subsidy worth about 35 cents for every dollar of mortgage interest she deducts (assuming her itemized deductions are typical for filers at that income level), whereas a nurse making $60,000 receives a subsidy of just 15 cents on the dollar. That’s both inequitable and inefficient. There’s no reason why a high-income person needs a larger tax subsidy to buy a home or why the economy is better off with this tilt; if anything, a buyer with a more modest income would likely respond more to a larger tax subsidy.
Retirement accounts like 401(k)s are another example. People with low and modest incomes are much less likely than higher-income people to have enough retirement savings, yet their 401(k) contributions receive a much smaller tax subsidy.
The Camp plan recognizes this inefficiency and reduces it. It sets tax rates of 10, 25, and 35 percent but caps the value of many individual deductions and exclusions at 25 percent. This limits the benefit for about the top 1 percent of filers to 25 cents on the dollar for a wide range of tax breaks, including eligible mortgage interest, contributions to retirement accounts like 401(k)s, employer-provided health insurance, and tax-exempt interest.
Making tax expenditures (like deductions and exclusions) more efficient and equitable has been at the heart of other tax reform proposals. Examples include the tax reform plans of Fiscal Commission co-chairs Erskine Bowles and Alan Simpson, the Bipartisan Policy Center’s Debt Reduction Task Force, and an advisory panel on tax reform that President George W. Bush established. President Obama has also proposed similar reforms to some major tax expenditures, as did Governor Romney. Now, fortunately, the House’s top Republican tax-writer has effectively embraced the goal of limiting the “upside-down” nature of many provisions of the tax code.