Tax Wars: The Deduction Puzzle

Tax debates are hard to follow, as everyone concedes that the subject is complicated.  Yet the rhetoric is easy to comprehend. Mitt Romney wants to lower marginal tax rates to stimulate growth, and is greeted with the predictable war cry of “tax cuts for the rich” by the pro-Democratic chattering classes.

The latest twist occurred right before the debate.  In an interview with Fox affiliate KDVR, Romney indicated he would consider a cap on deductions to address concerns about the deficit.  He suggested $17,000 as an appropriate target, which could be even lower for the very rich.

This is an intriguing concept. Although one could dismiss it as just another example of the horse trading that always goes on with tax policy, there is something deeper. The combination of lower rates and lower deductions is a nod to the principles of the flat tax, while keeping the basic framework of the current tax code.

It would also favor income-producing activity over consumption.  Affluent taxpayers currently get a break because of their ability to write off tax-advantaged consumption: patronage of the arts, mortgage interest on pricey homes, high property taxes and the like.

For example, let’s say Richie Rich gets a lower marginal rate courtesy of Mr. Romney.  Once deductions are capped, the incentive logic is clear.  He pays lower tax on his income in a steady state scenario.  Clearly a tax cut for the rich!  But he could wind up paying the same amount of tax as before if the ability to deduct his lifestyle expenses is curbed.  In the extremely simplified illustration below, that is exactly what happens. And to the degree his would-be deductions are over $58,400, he will pay more tax after the marginal rate cut.

Of course, real life and actual tax computations are much more complicated.  The devil of any tax reform project will be in the details: the basic rate and deduction structures, and the myriad of rules and regulations that are behind each line of a Form 1040.  But it does seem possible to craft tax reform that delivers a break to the rich if they invest, and “withholds” it if they opt for consumption.