On the Deficit Commission

SilverOz here.

The Deficit Commission released it's report today and I for one like most of it. Obviously, any cutting of the deficit and reigning in the growth of federal debt is not going to please everyone and there are several things in this report that I would do differently, but then I am not on the Commission. For this post though, I would like to concentrate on the tax changes recommended (specifically the "illustrative proposal").

The Commission proposes essentially ending all tax expenditures (what we know as deductions, credits, and subsidies) and then using the bulk of that savings to consolidate the tax code into three brackets and lower overall rates. What they don't tell us is where each of these brackets begins and ends (at least not where I could find in the report), which while interesting, doesn't impact the discussion since they do provide some breakdown of the impact on various income quintiles. Essentially what the commission is doing is making the effective tax rates the actual tax rates, which will make the code more fair at any given income point (but depending on ones opinion, not necessarily fair across different incomes (ie rich and poor)). Under the current code, two people making the exact same income living in the same city (and even neighborhood) can end up paying widely different amounts in taxes depending on all the various deductions and credits. And while these changes may not be good news for accountants, the simplification of the tax code would save money and time in its own right.

Under the Commission's illustrative proposal, they would eliminate all tax expenditures except for the earned income tax credit (EITC) and child tax credit, change the mortgage interest deduction into a non-refundable credit capped at a $500,000 mortgage, eliminate the tax-exempt status of new muni bonds, and tax all cap gains and dividends as ordinary income (among other things). These changes would then allow for brackets of 12%, 22%, and 28% (all with a standard deduction). The lower brackets would actually increase revenue generated (somewhat) by not utilizing all of the savings from the elimination of tax expenditures for the lower brackets, which allows some to be used to offset the deficit (ie the proposal does raise some taxes somewhere between $80-180 billion).

The change in tax liability by quintile goes up for each, but is definitely skewed towards the highest earners, with the top quintile losing about 3.7% in after tax income (the 3 middle quintiles are around a 1.5% loss and the bottom quintile a .4% loss), but with the top 1% seeing a loss of almost 8% and top .1% seeing a loss of almost 12% (so the tax code retains its progressive nature). What this means is that while everyone is going to see a tax hike, the biggest hikes in terms of percentage of income are skewed toward the wealthiest of Americans as opposed to the middle class.

Finally, I want to comment on the proposed elimination of the mortgage interest tax deduction, as that is an issue that both the left and right (well, the homeowning left and right) seem to get riled up about (full disclosure: I am a homeowner who takes advantage of the deduction). First, it is one of the biggest tax expenditures in the tax code (approximately $100 billion/year) and thus has to be addressed under any real reform. Second, the deduction rewards bad financial behavior, as it rewards those who either a) put down less than 20%, b) buy more house than they should afford (remember the housing bubble), or c) those with bad credit (who get higher interest rates). Also, the deduction is geographically skewed, as more of it's benefits are going to go to say the coasts and other high value areas over the midwest. Finally, the deduction is really nothing more than a reward for taking on debt, something that in light of the recent recession maybe we shouldn't be encouraging anymore (it doesn't reward home ownership, as the cash buyer gets nothing out of it except a higher price to buy at).

In conclusion, I actually like the bulk of the Commission's report and would love to see a bipartisan approach (like this one) on the deficit/debt issue. As a realist however, I know that this report has zero chance of passing and real efforts to reduce our deficit/debt will only come when forced (see Greece).

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