July 19, 2011

In the negotiations on the debt ceiling, Vice President Biden initially pushed for a $2.4 trillion deal — with $2 trillion in spending cuts and $400 billion in revenue raisers. Although President Obama recently suggested a larger deal with higher tax rates for the wealthy, Republicans have uniformly rejected that idea.

Some moderate Republicans, however, seem willing to consider a package of revenue raisers that would reduce the economic distortions of the tax code by closing corporate loopholes and limiting expansive personal deductions. In a $2.4 trillion deal, here’s how to put together a reasonable package of $400 billion in such revenue raisers over 10 years.

On the corporate side, Congress could raise a total of $150 billion over 10 years by adopting four measures:

First, Congress should eliminate the $60 billion tax subsidy for producing ethanol. This loophole has driven up the price of corn and other foodstuffs without decreasing the use of energy. It would be much more efficient for the United States to import low-cost ethanol from Latin America, where it is made from sugar cane.

Second, changing corporate accounting standards from LIFO (last in, first out) to FIFO (first in, first out) would raise $70 billion over 10 years. The rest of the world uses FIFO, which matches units sold by a company with the cost of the units it received first into inventory. This usually increases corporate profits because the price of inputs tends to rise over time. But the change in accounting methods would significantly benefit U.S. multinationals by harmonizing U.S. and global standards.

Third, Congress could raise $17 billion by taxing “carried interest” earned by investment professionals at ordinary income rates (35 percent) rather than capital gains rates (15 percent). Managers of hedge funds typically receive a base fee plus a carried interest equal to 20 percent of the fund’s realized gains. Such carried interest constitutes incentive pay for these managers and should be taxed at ordinary income rates like other forms of compensation.

Fourth, Congress should eliminate the allowance for accelerated depreciation of certain capital expenses such as corporate jets. Although this is a rhetorical favorite of Democrats, it would raise only $3 billion over 10 years.

On the individual side, Congress could raise substantial revenue by imposing several limits on the mortgage interest deduction. Taxpayers are currently allowed to deduct mortgage interest on second or vacation homes. This, obviously, does not promote home ownership since these people already have first homes. Similarly, we allow mortgage interest deductions on home equity loans — second mortgages on existing homes. These deductions do not promote home ownership because these loans are typically spent on consumer goods or services unrelated to home improvement.

Congress could raise $150 billion in revenue over the next decade by ending mortgage interest deductions on second homes and home equity loans, as well as restricting such deductions to mortgages of as much as $500,000 per couple — instead of the current limit of $1 million per couple. By offering interest deductions on $1 million mortgages, we are not promoting home ownership; these people would have bought homes in any event. Rather, we are providing government subsidies for the purchase of large homes by wealthy taxpayers.

To raise the final $100 billion of revenue, Congress could modify the approach to insurance premiums in the recently passed health-care legislation. That legislation imposed a “Cadillac” tax, effective in 2018, on any insurance company offering health-care plans with premiums of more than $27,500 per year. Instead of the “Cadillac” tax, Congress could cap the currently unlimited exclusion for employer-based health-care premiums at $23,000 for families (and $8,500 for singles), effective in 2013. For example, a family with health-care premiums of $24,000 per year would pay income tax only on the last $1,000.

This cap would have a narrow impact; approximately 80 percent of workers would not be affected. Yet the cap would help constrain health-care expenditures by limiting the tax subsidies for the most expensive plans.

In short, Congress could include a revenue component of $400 billion in a $2.4 trillion deal on the debt ceiling without violating the Republican commitment not to increase tax rates. Instead, Congress could eliminate special-interest provisions for corporations and restrict overly expansive deductions for individuals. The inclusion of these revenue raisers would not only resolve the debt-ceiling debate in a more balanced manner but also would reduce some of the economic distortions resulting from the federal tax code.

Robert Pozen is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. His latest book is “The Fund Industry: How Your Money Is Managed.”