The Big Hidden Tax Ideas In Obama’s Budget

President Obama’s budget proposals have been criticized for not solving the fiscal shortfall, not curbing Medicare growth, not balancing social security, and not specifying broad-based tax reform. And while it is widely acknowledged that nothing major is going to happen in 2012 legislatively, the administration’s budget contains at least two “big ideas” that represent fundamental building blocks of a better revenue system.

Done right, they could 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.)

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 as 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.

We need some big ideas. Revenue increases are going to have to be part of the medium- and long-term fiscal solution. The required spending cuts from solving the budget problem on the spending 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.

Finally, on sheer efficiency grounds, the experience of the last 30 years shows that raising taxes is a better way to control spending — by making the cost of spending clear and current — than is deficit spending. In the 1980s and the 2000s, we cut taxes and spending rose. In the 1990s, we raised taxes and spending fell.

Eventually, after the economy is well on its way to full recovery, we need a fiscal solution — spending cuts and tax increases. The president’s budget does not propose the ultimate fiscal solution, but it contains some ideas that would make for a more stable, adequate, fair and efficient revenue system, which will be a crucial part of the overall solution.