A possible compromise on the Bush tax cuts

November 9, 2012

Speaker John Boehner seemed to extend an olive branch by saying that Republicans were willing to raise "some additional revenue, via tax reform" — just not by hiking tax rates. That would seem to rule out permitting the Bush tax cuts to lapse for the wealthy. Or would it?


Washington in one photograph. (Jewel Samad --  AFP/Getty Images)

Letting the top marginal rate snap back to 39.5 percent raises $32 billion in annual revenue, according to JPMorgan's chief economist Michael Feroli. But the Bush tax cuts include other tax breaks for upper-income Americans that could be allowed to expire instead, raising revenue without directly raising individual rates by limiting tax exemptions and deductions. These provisions could be "potential areas of compromise," Feroli points out.

For example, the Bush tax cuts temporarily eliminated what's known as the Pease limit on tax deduction for high-income earners. If that deduction comes back, then all individuals with incomes above $177,550 in 2013 would see their deductions reduced by 3 percent of the amount their income exceeds that threshold, although the reduction would be capped at 80 percent. (My colleague Dylan lays this out in more detail here.) This would raise the effective tax rate on higher-income households by about 1.2 percentage points and  generate about $9 billion annually, according to JPMorgan's Feroli. 

The Bush tax cuts also eliminated the personal exemption phase-out (PEP) If that's restored, then single individual filers with incomes above $170,000 and married joint filers above $265,000 would see some or most of their personal exemption deductions eliminated. (Their average deduction is about $3,800.) Feroli estimates that restoring PEP would generate about $3 billion annually.

Put together, restoring Pease and PEP would generate about $12 billion annually, targeting high-income households to raise revenue without directly raising tax rates, according to the JPMorgan report. Since these changes are already scheduled to happen by law, they wouldn't require new legislation, which could make them politically easier to implement. "In one sense the reason to do it is that it's there," says Roberton Williams, senior fellow at the Tax Policy Center.

The downside? These changes wouldn't raise that much money in the scheme of things, and significantly less than the $50 billion annually that Obama wants by letting all the Bush tax cuts for upper-income taxpayers expire. Fiscal conservatives might consider the Pease and PEP changes to be essentially rate increases on the wealthy, albeit more indirect ones. "You would get a similar effect just by raising the rates at the top end," said Williams. "A lot of why we do things is because of how they look."

From a policy perspective, it's also not the most effective way to do tax reform. You could get significantly more revenue by capping deductions at 2 percent of income, as Harvard's Martin Feldstein has proposed, which you could also limit to upper-income earners. But that would put a much bigger squeeze on tax breaks that have staunch defenders, like mortgage-interest deduction. Obama has proposed a more limited deduction cap on high earners, though that would raise only about $164 billion over 10 years—not much more than the PEP/Pease approach. (You could raise a whole lot more money by raising taxes on capital gains and dividends, but that would be raising rates directly, which Boehner still says is a nonstarter.)

In essence, it's the same lesson that we learned with Mitt Romney's tax plan: Lowering rates while raising revenues through eliminating tax expenditures is really hard -- and it gets much harder if you mainly want to raise taxes on the rich.

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Ezra Klein | November 9, 2012