Raising Democrats’ Taxes

It may be hard to eliminate the biggest tax expenditures.

Michael Barone
Monday, November 21, 2011

Supercommittee members Sen. Pat Toomey and Rep. Jeb Hensarling are taking flak from some conservatives for proposing a deal including increases in “revenues,” and a Washington Post reporter had some fun insinuating that they were backing a tax-rate increase.

As this is written, no one knows what the supercommittee will do (or not do), but it’s worth taking a look at what Toomey and Hensarling actually were talking about. It may not matter now, but could after 2012.

They were raising the possibility, as Barack Obama’s Bowles–Simpson commission did last December, of a tax-reform bill that, like the 1986 tax-reform act, would eliminate tax preferences and lower tax rates.

The 1986 bill was passed with bipartisan support, and there’s a potential for bipartisan support again.

The problem in putting such a measure together is that most really egregious tax preferences don’t add up to much money. Just as the big money for long-term spending cuts must come from changes in entitlements — Social Security, Medicare, Medicaid — so the big money you can get from eliminating tax preferences comes from three provisions that are widely popular.

The three are the charitable deduction, the mortgage-interest deduction, and the state-and-local tax deduction.

The charitable deduction should probably be off the table. The Obama administration has proposed reducing it for high earners. But this obvious attempt to channel flows of money away from the voluntary sector and toward the federal government went nowhere even when Democrats controlled the House and had a supermajority in the Senate. It’s anathema to many Democrats and just about all Republicans.

The mortgage-interest deduction may seem similarly sacrosanct. But the fact that the vast bulk of the “tax expenditures” — the money the government doesn’t receive because taxpayers deduct mortgage-interest payments from total income — goes to high earners with big, expensive houses.

Traditionally it’s been argued that government should provide incentives for homeownership, because homeowners more than renters have a stake in their community. But it’s obvious now that we have over-incentivized homeownership, with government encouraging loans to non-creditworthy borrowers.

At the same time, high earners don’t need an incentive to buy a home. If we limit the mortgage-interest deduction to some amount near the median housing price, some folks will still buy $1 million homes, though they may finance them a little differently. And the government can get more revenue without an economy-crushing tax-rate increase.

Similarly, what about a cap on the state-and-local tax deduction? Initial conservative reaction will likely be hostile: Why increase some people’s federal tax bills? Isn’t that attacking a core Republican constituency?

Actually, it’s not. The state-and-local tax deduction is worth a lot more to high earners than to modest earners, and it’s worth nothing to the nearly half of households that don’t pay federal income tax.

But it’s worth the most to high earners in high-tax, high-spending states. Those people are more likely to be Democrats than Republicans. The 2008 exit poll tells the story.

Nationally, voters with incomes over $100,000 voted 49 percent Obama to 49 percent McCain in the presidential race. Those with incomes over $200,000 voted 52 percent to 46 percent for Barack Obama.

In high-tax, high-spending states, Obama did even better with high earners. He carried $100,000-plus voters with 55 percent in Connecticut, 56 percent in New York, 52 percent in New Jersey, 55 percent in Maryland, 54 percent in Illinois, and 57 percent in California.

All those states have high state income taxes except for Illinois, and it increased its income-tax rate by two-thirds earlier this year. And those states contain a huge share of the nation’s highest-priced housing.

In contrast, in low-tax, low-spending states with relatively inexpensive housing, $100,000-plus voters favored John McCain, who won 65 percent of their votes in Texas, 55 percent in Florida, and 61 percent in Georgia.

It is no coincidence that the high-tax, high-spending states tend to have strong public-employee unions. In effect, the unlimited state-and-local tax deduction is a federal subsidy of the indefensibly high pay, benefits, and pensions of public-employee union members. Limiting the state-and-local tax deduction would create a political incentive to hold those costs down.

So ironically, limiting high earners’ lucrative tax deductions may prove a harder sell among Democrats than Republicans. But maybe Republicans should give it a try anyway.