TOPICS > Economy

Lawmakers Consider Cutting Tax Deductions to Bring Down the Deficit

December 10, 2012 at 12:00 AM EST
While tax breaks are popular, their future may be limited. Congressional leaders are deliberating on how they can increase revenue in order to bring down the deficit, and deductions may be on the chopping block. Paul Solman explores write-offs for charitable donations, mortgage interest and state and local taxes.
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JUDY WOODRUFF: Now back to the battle over the fiscal cliff.

Much of the debate has centered on the question of whether to raise tax rates on high income earners. But many experts are also raising questions as to whether major tax deductions should be limited or even eliminated entirely.

The NewsHour’s economics correspondent, Paul Solman, was in Washington recently to examine the possible impact of such a change. It’s part of his ongoing reporting Making Sense of financial news.

PAUL SOLMAN: At Saint Martin’s Catholic Church last Thursday, they queued up early for clothing and food. The church, like any nonprofit, relies on charitable donations. But limiting or even axing charitable deductions could be part of a deal to avoid the fiscal cliff.

Look, says Roberton Williams of the TaxPolicyCenter, given our national debt, some sort of tax hikes are inevitable.

ROBERTON WILLIAMS, TaxPolicyCenter: We want to increase revenues. We have got two ways to do that. One is just to raise the rates we’re paying, tax the same income we have got right now, but hit it harder, get more revenue.

The alternative is to tax more, get rid of the deductions, exclusions, exemptions, things that reduce our taxable income. We tax more at today’s rates, we bring in more revenue.

PAUL SOLMAN: Itemized deductions are the first form of tax breaks on the table. Used by 30 percent of taxpayers, they cost the government over $200 billion a year, about a fifth of this year’s deficit. Charitable donations alone cost $40 billion a year. But ending them is costly too.

ROBERTON WILLIAMS: Anybody who gives money away and has itemized this, taxes will go up. They will pay more. And that’s what we’re all about, trying to get rid of these.

But at the same time, they will likely give less to charities. If I don’t get the deduction, it’s going to cost me more after taxes to give away money.

PAUL SOLMAN: And, say nonprofit leaders, if the rich stop giving, the poor stop getting.

MAN: We’re here to urge Congress to protect a 100-year-old tradition.

PAUL SOLMAN: A tradition that hundreds on Capitol Hill last week were working to uphold. And who doesn’t want places like Saint Martin’s to survive?

ROBERTON WILLIAMS: The organizations that we classify as charitable, churches, hospitals, universities, arts, those are all things we think are good. The government is encouraging contributions to that by giving this deduction. Take it away, fewer contributions and places like this will be worse off.

PAUL SOLMAN: The biggest tax deduction of all is also popular, the $84 billion-a-year mortgage interest deduction.

ROBERTON WILLIAMS: If you’re paying interest on your mortgage, you can deduct that, reduce your taxable income, and therefore pay less to the IRS.

PAUL SOLMAN: And does this deduction have a demonstrably effect on people’s behavior, what they do when they’re buying houses?

ROBERTON WILLIAMS: It affects their behavior, but in an odd way. It doesn’t induce people to buy a house in the first place. It doesn’t change their likelihood of buying. What it does do is induces them to pay more for a house, to buy a bigger house. We’re subsidizing big houses, not homeownership.

PAUL SOLMAN: The amount you save depends on your marginal tax rate, the rate applied to money you earn once you reach your highest bracket.

ROBERTON WILLIAMS: If you’re in the 35 percent tax bracket, you save 35 cents for every dollar you deduct. If you’re in the 15 percent tax bracket, you only save 15 cents for every dollar. That means, in terms of the home mortgage, we’re subsidizing rich people a lot more than we’re subsidizing lower-income people.

PAUL SOLMAN: Some people misunderstand this and think that once you’re at the 35 percent bracket, that means all your income is taxed at 35 percent. It’s only income above a certain threshold, right?

ROBERTON WILLIAMS: Everybody walks through the bottom tax brackets. Everybody pays 10 percent tax on those first $8,000 or $15,000 of income, and then 15 percent on the next piece.

And at the very top, you’re paying 35 percent on that last piece of income. And that’s where the deductions come in. They’re reducing that top income, saving you money at your top tax bracket rate.

PAUL SOLMAN: So, what’s the argument against removing the mortgage interest deduction?

ROBERTON WILLIAMS: One, there will be people who can no longer afford their mortgages. If they don’t get that tax savings, they don’t have enough to cover the mortgage payments.

Secondly, there will be an immediate drop in housing prices. People will not be willing to pay as much for housing. And, therefore, prices will come down. Every homeowner will suffer a capital loss.

PAUL SOLMAN: Next stop, the WilsonBuilding, which houses D.C.’s mayor and city council, next major tax break, state and local taxes, deductible in full from taxable income. This costs the federal government about $47 billion a year, almost 5 percent of the annual deficit.

So what’s the objection to getting rid of the state and local tax deduction?

ROBERTON WILLIAMS: The deduction for state and local taxes lowers the cost to citizens of paying those state and local taxes. It means those governments can charge higher tax than they otherwise would.

Take that away, and they will either have to lower their taxes, lower their revenues at a time when they’re in trouble themselves, or it’s going raise the cost to the citizens, who won’t be happy about it.

PAUL SOLMAN: Please pardon the literal-mindedness, but as lawmakers rush to rescue the economy from the fiscal cliff emergency, they have focused, as have we thus far, on itemized deductions.

But when it comes to tax breaks or preferences, says Roberton Williams:

ROBERTON WILLIAMS: It’s not just deductions. It includes things like exclusions of income, the biggest one of which is the fact that we don’t tax you on the premiums your employer pays for the health insurance you get. It’s much bigger than anything we have on the deduction side.

And it’s not the only exclusion we have, the exclusion of all the contributions to retirement plans, your 401(k), your IRAs, also very, very large.

PAUL SOLMAN: But we’re not going to start counting as income the money that our employer puts in for our medical insurance, are we? Or, for that matter, we’re not going to get rid of the exclusion for putting money into a 401(k) to defer taxation, but encourage us to save more.

ROBERTON WILLIAMS: It’s pretty unlikely we are going to count all of that income. But we’re already scheduled to count some of the premium paid your employers.

In 2018, the Obamacare will start taxing the very highest premiums, the Cadillac plans. Anything over that will suffer an excise tax that is like adding the tax on the income side.

We’re not likely to do it on the retirement savings side because people aren’t saving enough for retirement anyway. We don’t want to do anything that will discourage them from putting more money into those accounts. And, certainly, taxing those contributions would discourage the buildup of retirement savings.

PAUL SOLMAN: We could have spent the entire week in Washington itemizing tax breaks, of course, child credit, earned income tax credit, special rates for dividends and capital gains. But time is short. So we ended our tax tour here with the last, often-heard solution.

One proposal we have been hearing more about is simply capping deductions, $25,000, $50,000. Anything beyond that, you can’t deduct. What does that do and how does that work?

ROBERTON WILLIAMS: The problem with capping the deductions, rather than getting rid of them entirely, is you lose a lot of revenue. Capping at $25,000 loses almost half the revenue you would get by getting rid of this deduction completely. Capping it $50,000 loses almost two-thirds. There’s just not enough revenue if you do only that.

There’s a lot more money if you go after all the tax breaks that people have. We estimate roughly $1.1 trillion a year in revenue the government gives up because of all the tax breaks, the lower rates on gains and dividends, the exclusions of lots of kinds of income, the deductions, the tax credits.

Get rid of all of that, and we would bring in an additional nearly trillion dollars a year. That’s enough to solve the revenue problem, but it’s not going to happen.

PAUL SOLMAN: Why not?

ROBERTON WILLIAMS: People really like the breaks they’re getting. They want them to be part of the tax system. They save them money. Take them away, they will be really angry. And so they’re going to be out there defending them as strongly as possible in these negotiations.

PAUL SOLMAN: And, unfortunately, in the process, making the fiscal cliff harder to avoid.

GWEN IFILL: Want to know how the fiscal cliff could impact your tax bill? Calculate how much you would pay under different policy scenarios on Paul’s Making Sense page.