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Proposal To Limit US Tax Deductions Resurfaces

by Mike Godfrey,, Washington

03 May 2013

The resurfacing, in a recent newspaper article, of a proposal by Harvard economics professor Martin Feldstein to limit itemized deductions at 2% of an individual taxpayer's income, so as to reduce the United States fiscal deficit, would slow economic growth, according to a new analysis by the Tax Foundation (TF).

In his op-ed in the Washington Post, Feldstein wrote that, in order to break the budgetary political impasse and replace the current spending "sequester," he favored "a cap of 2% of adjusted gross income (AGI) on the tax benefit that an individual receives from deductions and from the exclusion of municipal bond interest and of the value of employer payments for health insurance. For someone with a 25% marginal tax rate, that 2% limit on the reduction in taxes translates into a limit of 8% of AGI on the deductions and exclusions."

The 2% cap would be applied to all deductions except the one for charitable contributions, and, he calculated, "would produce about USD140bn in additional revenue if it were applied in 2013. Over the next decade, the additional deficit reduction would total more than USD2.1 trillion."

While agreeing with Feldstein's calculations of additional revenue on a static conventional basis, the TF's dynamic simulation (where macroeconomic aggregates, such as national output, employment and investment, are affected by the increased taxes) finds that the higher marginal tax rates stemming from the cap would depress economic activity.

The TF's model estimates that once the US gross domestic product (GDP) has adjusted to the new tax rules, "the smaller economy would have a negative feedback on tax revenues, taking away an estimated 15% of the money the Feldstein limitation would otherwise collect. … For every USD1 of new revenue raised, the plan would lower GDP by 73 cents. In assessing the plan, policymakers should be aware of this cost in terms of lost economic output."

The TF believes that "a superior strategy would be to use deduction limits to lower marginal tax rates, either on their own or in conjunction with a long-term plan for deficit reduction. … Using additional revenue to lower marginal tax rates, or splitting the revenue between deficit reduction and lower rates, would create an economic boost that would provide a greater benefit to a greater number of Americans."

It is calculated that the 2% cap on deductions could also finance a 17% across-the-board cut in individual income tax rates, stimulating the economy, with private business GDP growing by 1.2%. At the same time, growth feedback effects would see federal tax revenues actually increase by USD38bn, despite the reduction in rates.

In addition, as a means of cushioning the economic damage if the plan were adopted, while still substantially lowering the federal deficit, the TF has also looked at the effect of using half the additional revenue to reduce the deficit and the other half to finance an across-the-board statutory rate cut.

If the 2% cap was to be imposed and all statutory individual rates were cut by 8.5% percent, the TF's model estimated that revenue gains would be approximately USD100bn annually, while GDP increased very slightly by 0.2%.

TAGS: individuals | tax | economics | fiscal policy | gross domestic product (GDP) | tax rates | United States | tax breaks | individual income tax

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