New hope for a tax compromise is starting to spring up around the idea of capping or eliminating tax deductions to raise revenues without hiking rates. In recent days, John Boehner and Glenn Hubbard have suggested that they'd be open to the idea, with the assumption that the Bush tax cuts would stay in place.
In fact, Obama has put one version of this idea before Congress: a 28 percent deduction cap that would reduce the tax write-offs that high-income earners could claim. The problem is that it doesn't raise all that much revenue unless tax rates also go up at the same time. It's a reminder of the dilemma that was at the heart of Mitt Romney's tax plan: It's very hard to raise much revenue through limiting deductions without hitting the middle class or going after tax breaks whose repeal wouldn't pass muster within the current Congress (e.g., employer-sponsored health care).
Obama's cap would limit deductions for the top three tax brackets. Currently, the value of deductions are pegged to your individual tax rate: If you are taxed at 33 percent, your deductions are worth 33 percent of their total value in write-offs. But under Obama's plan, deductions could only be 28 percent at most, lowering the value of tax-write-offs for higher-income Americans.
The problem is that it doesn't raise all that much revenue, relatively speaking: According to the Tax Policy Center, Obama's deduction cap would generate $164.2 billion over ten years if the Bush tax cuts stay. By comparison, letting the Bush tax cuts expire for income above $250,000 would generate close to $1 trillion in revenue over 10 years.
There are other ways to generate more tax revenue without raising rates. For example, Harvard economist Martin Feldstein has proposed limiting the value of tax expenditures to 2 percent of adjusted gross income. That would raise a lot more revenue — $520 billion, the TPC estimates — but it would also end up hitting much of the middle class.
These are the same problems that dogged Romney throughout his campaign, because the limitations of our tax code haven't changed. That said, lawmakers have a comparatively smaller task ahead of them: Romney's sweeping tax cuts would have required raising $5 trillion in revenue, to avoid increasing the deficit. Obama's budget, by contrast, calls for $1.5 trillion in new tax revenue. And Democrats may demand at least $1 trillion — i.e. what getting rid of the Bush tax cuts on the wealthy would have generated — especially if and when Republicans make their own demands on entitlements.
That's still far from what an Obama-style deduction cap would generate on its own. That's why top Democrats like Rep. Chris Van Hollen are saying that limiting deductions could be part of a tax deal but can't be the only solution.