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Let them eat nonrefundable credits

Erskine Bowles, Alan Simpson, Alice Rivlin, and Pete Domenici, all of whom back converting tax deductions to credits (REUTERS/Jonathan Ernst)
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Recent reports suggest that Democratic policymakers are warming to a proposal Mitt Romney made on the campaign trail to cap tax deductions without cutting any specific tax breaks. House Speaker John Boehner and former Romney economic advisor Glenn Hubbard are apparently also on board with the plan.

Such a cap could take any number of forms. Romney floated an option that would cap deductions at a dollar amount, throwing out $17,000, $25,000 and $50,000 as potential upper limits, while Harvard's Martin Feldstein has suggested capping both deductions and non-deduction breaks at 2 percent of adjusted gross income.

But as tax expert Joel Slemrod told me on Sunday, there's a big problem with plans of that kind, in that they totally eliminate whatever incentive effects tax deductions have on the margin. Suppose you're a millionaire deciding how much to give to charity. If you were giving less than $17,000, then a $17,000 cap wouldn't reduce your incentive to give. But if you were giving more than that, you'd be encouraged to reduce your giving, or at the very least to not increase it. Insofar as we want to preserve the incentives that tax breaks provide, this is a big problem.

However, there are cap-like proposals that don't have this problem. Perhaps the most promising idea is replacing all deductions with credits. Currently, tax deductions are worth more the higher your tax bracket. If you're in the 35 percent tax bracket and give $1,000 to charity, that saves you $350 on your income taxes. If you're in the 10 percent bracket and make the same donation, you only save $100.

But if the charitable deduction were changed to a credit worth, say, 20 percent of all donations, then everyone would get the same benefit. That would reduce the effect of deductions on high earners, but increase it for lower-income people. But it would still keep the subsidy at all levels. Someone who gave that same $1,000 to charity would cut their tax bill by $200, whether they were rich or poor.

That sort of system would also ensure that there was never a point where giving to charity didn't reduce your tax burden on the margin. And because the change reduces the benefit for those who claim the most deductions, a conversion like this stands to raise a lot of revenue.

Many tax reform plans include a change of this type. The Bush administration's presidential panel on tax reform suggested replacing most deductions with a 15 percent credit. Both the Simpson-Bowles and Domenici-Rivlin deficit reduction plans convert the mortgage interest and charitable deductions to credits, in both cases set to the lowest income tax rate suggested by the plan (12 percent for Simpson-Bowles, 15 percent for Domenici-Rivlin). Domenici-Rivlin also makes the credit refundable, which would make the change even more progressive by making the subsidies available to people who make too little to have a positive income tax burden.

What could something like this raise? The Tax Policy Center estimates that converting just the mortgage interest deduction into a 15 percent, nonrefundable credit would raise $378 billion over 10 years. Replacing the charitable deduction to a refundable credit would raise about $10 billion a year (or $100 billion over 10). The Obama administration has proposed limiting the benefit from deductions to 28 percent, a similar but much milder reform which raises $164.2 billion over 10 years.

The point: there's real money here, and unlike more blunt caps, it doesn't eliminate incentives. If Obama and House Republicans are serious about raising revenue without increasing rates, credit conversions could be a promising avenue.