Tax deductions are subtracted from adjusted gross income lowering the base on which taxes are calculated. Tax credits, on the other hand, are subtracted in full from a taxpayer's bill.
So if the above script sounds like a TV ad for tires or cell phone plans, consider it marketing for those seeking re-election. We Americans like our tax credits and deductions. In an increasing homogenized world, we value home ownership in the U.S., even if it is subsidized with reduced taxes. And we prefer a variety of private health insurance, particularly if our employers pay for it, thus reducing our taxed income and their profits. Much of our entertainment and social life centers around universities, conservation and charity events supported through tax deductible contributions.
God help the politician who gets between us and our tax credits and deductions.
It is common knowledge that the U.S. federal government is plagued with persistent yearly deficits adding on to the size of our public debt, much of which is held by foreign governments and kicked down the road to the next generation. Partisans, on both sides of the issue, realized that the deficit can only be eliminated by increasing tax revenue, reducing government spending or some combination of both. Releasing certain activities from taxes or increasing government spending is deficit neutral. Therefore, some economists refer to tax credits and deductions as “tax expenditures.” Others object strenuously to this term because it implies that certain portions of earned household income belong to government to be used as directed.
Ironically, both Mitt Romney and John McCain in the last days of their unsuccessful campaigns addressed, respectively, capping deductions and eliminating the tax advantage of employer-provided health insurance. The time has come to ask the question, “Have tax credits and deductions grown to unacceptable levels?” The answer is probably yes. However, there is absolutely no consensus or political will concerning which credits and deductions to eliminate.
A simple route out of this dilemma without generating fierce opposition is to maintain existing credits and taxes but to cap total deductions by a certain percentage of adjusted gross income. Martin Feldstein, a respected economist, has come up with a plan to cap deductions that could reduce the national debt by $2.1 trillion over the next decade. He proposed limiting the tax savings from deductions and exclusions to 2 percent of adjusted gross income.
Consider a person with an adjusted gross income of $100,000 claiming $10,000 in permissible deductions. Presently, if subject to a 25 percent marginal tax rate, the value of these deductions to the taxpayer is $2,500. Under the Feldstein plan, the value of claiming $10,000 in deductions for this person would be capped at $2,000, thereby increasing federal tax revenue by $500. (Note: the taxpayer, in this example, still retains $8,000 in deductions of his or her choice.)
Feldstein maintains that a cap on deductions would reduce after-tax income proportionately more for higher-income individuals. This assumes, of course, that higher income persons presently claim deductions and exclusions at a higher percentage of income than others. Furthermore, a cap would encourage most individuals who now itemize to instead take the standard deduction.
Feldstein, unsurprisingly, is willing to modify his very own proposal. He considers allowing employees to exclude from the cap the first $8,000 of employer-paid health insurance. He also suggests retaining the existing deductions for all charitable contributions. Feldstein argues that these contributions do not benefit the taxpayer but provide important support for universities, religious and cultural institutions and hospitals. Reducing financial support for intermediary institutions between family and state would profoundly change American society.
Tax credits and deductions are the currency in which politicians deal. If tax credits and deductions were to somehow disappear overnight, they would soon be reincarnated in another form. Given the present government debt crisis, one pragmatic option is to cap deductions in return for keeping overall tax rates constant.
But the truth is that federal finances cannot be stabilized by caps and reduced discretionary expenditures. Growth in entitlements must somehow be addressed.