Easier, Fairer Taxes

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

April 12, 1997

WASHINGTON—Tax season is upon us, and the President and the Republicans are talking about child tax credits, education tax credits, expanded I.R.A.’s and capital gains tax cuts. We’ve come a long way from last year’s calls for a flat tax and other radical simplifications.

Yes, the tax code needs change. But there are alternatives to either junking the system, which is impractical, or endlessly tinkering at its margins. One option is to eliminate the deduction for itemized expenses—for mortgage interest, large health expenditures, charity donations and state and local taxes—and instead offer taxpayers a 15 percent tax credit for such costs. To offset this smaller deduction, the extra revenue generated by this reform could be put toward a modest across-the-board tax cut.

Besides not raising most people’s taxes, this plan would make filing and enforcement easier: Many more people would be better off taking the standard deduction than itemizing, and those who would still itemize would have less incentive to finesse the system to maximize their deductions.

It would also make the system fairer, because itemized deductions are regressive. Only 28 percent of taxpayers itemize, but this includes 90 percent of households with income above $75,000 and less than 10 percent of those below $30,000. The higher the tax bracket, the more itemizing helps. A wealthy household has its taxes reduced by as much as 40 cents for every dollar of mortgage interest it pays, while a low-income household might save only 15 cents per dollar. Moreover, a homeowner can use a tax-deductible home equity loan to buy a car or take a vacation; a renter can’t.

Some say that eliminating the mortgage-interest deduction would devastate real estate markets and home construction. But history shows that such claims are exaggerated. In 1980, when the top tax rate was 70 percent and mortgage interest rates were at 12.7 percent, the annual deduction was worth up to 8.9 percent of a loan. Now, with the top tax rate down to around 40 percent and mortgage rates closer to 8 percent, the deduction is worth, at most, 3.2 percent of the loan. Yet home ownership rates have changed little as the value of the deduction has plummeted.

If the deduction were converted to a 15 percent tax credit, this credit’s value would be about 1.2 percent of a loan. Yes, this is smaller than under the current system—but compared to the change over the last 15 years it isn’t that dramatic a drop. And the Treasury would gain over $50 billion per year if all itemized deductions were converted into a 15 percent credit.

This new revenue could be used to reduce all marginal tax rates of those penalized by the loss of the itemized deductions—those in the 28 percent bracket and higher—by about 3 percentage points. We could also eliminate a handful of ”hidden” taxes like the restrictions on personal exemptions that apply to high-income taxpayers.

Lower rates, fewer loopholes, fairer taxes, simpler filing—who could ask for anything more for April 15?