Amidst the myriad proposals in President Obama’s budget are two “big ideas” that would raise revenue in a progressive manner without raising taxes. These important ideas should be emphasized in the discussion of tax and fiscal reform that the country should be having and will have to have sooner or later. (The president also proposes letting the Bush tax cuts for high-income households expire, which would raise marginal tax rates modestly for high-income households.)
Some background: revenue increases are going to have to be part of the medium- and long-term fiscal solutions. The required spending cuts from solving the budget problem on the tax side alone would be too draconian to gain public support, and durable budget deals that addressed earlier fiscal problems in the 1980s and 1990s contained a balance of spending cuts and revenue increases. In addition, the public supports having a combination of revenue increases and spending cuts, rather than all one or the other. And, if shared sacrifice is a key theme for fiscal solutions, tax increases are the only way to ensure that households with very high income participate meaningfully in helping to close the fiscal gap the nation faces.
The first “big idea” is a specific proposal in the budget — to limit the benefit from itemizing deductions to 28 cents on the dollar. Current itemized deductions are expensive, regressive, and often ineffective in achieving their goals. The mortgage interest deduction, for example, does not seem to raise home ownership rates. Limiting the benefits of the deductions for top income households is a way of reducing the distortions created by the tax code, making taxes more progressive and raising revenue. All good ideas.
The second “big idea” is to repeal the alternative minimum tax and replace it with the so-called Buffett rule, which would establish a 30 percent tax rate for taxpayers with income above $1 million. As a guideline for tax reform, rather than a specific budget item, this proposal would move the tax system in the right direction, with a caveat. The alternative minimum tax was originally designed to stop taxpayers from taking excessive amounts of deductions or tax-preferred income, chiefly in the form of capital gains. However, as the tax has evolved, it now increasingly falls on middle-income taxpayers, and liability is mainly due to having many children or living in a high-tax state, hardly what most people think of aggressive tax sheltering techniques. Replacing the AMT with a tax system that truly increased the progressivity of taxes and closed loopholes — what the Buffett rule is intended to do — would be an improvement.
However, there is that caveat — it will not be possible to do that in the existing system, without imposing either a big jump in taxes as households reach $1 million in income, or high effective marginal tax rates over a range in which the tax phases in. That is probably why the Buffett-AMT switch is being a proposed as a guideline for reform, rather a budget line item. Done right, and done as part of a broader reform, the switch would broaden the base, raise revenue, and reduce inequities in the tax system — all the right directions for tax reform.