taxes and the budget: part ii

As mentioned before, one of the tax proposals in the Obama Budget calls for itemized deductions to be taken only against a base 28 percent rate rather than the higher rate (36 percent, 39.6 percent) that might apply to an individual taxpayer. This and other tax increases are designed to pay for a national health care system and, more generally, to redistribute money between income classes. The proposal has an interesting history, having appeared in various 1980s-era tax reform plans and, in more attenuated form, in the itemized deduction "phaseout" under current law. It is also heir to a distinguished, if confusing, policy discussion.

Those of you who have studied tax policy may remember the debate between William Andrews and Mark Kelman about itemized deductions. Andrews suggested that such deductions (notably the medical and charitable variety) were a legitimate part of income measurement, since spending of this nature did not involve a "preclusive" application of resources in the manner of ordinary consumption activities. According to this analysis, there was no more reason to object to such deductions than (say) ordinary business expenditures. Kelman, by contrast, viewed medical or charitable expenses as essentially another form of consumption, so that the deduction appeared anomalous if not wholly unjustified. For good measure, Kelman accused Andrews of being overly concerned with petty horizontal equity issues as opposed to more serious matters of distributional justice, a feeling which may have contributed to Kelman's departing the tax field as he did shortly thereafter.

From a policy perspective, the Andrews-Kelman debate--if a bit old-fashioned at times--remains relevant to today's proposal. If one, like Kelman, views itemized deductions as essentially a subsidy for preferred forms of consumption, cutting them back for rich taxpayers seems reasonable if not actively desirable. (It is an inevitable feature of deductions that they benefit wealthy more than poorer taxpayers, because they apply to a higher tax rate and because the rich tend to have more of them, anyway.) If, like Kelman, one sees them as a part of income measurement, the cutback is harder although not wholly impossible to defend. I personally find the whole debate a bit abstract for my tastes, although I do think that it depends somewhat which deductions you are talking about: charitable contributions sound a lot more like voluntary consumption to me than (say) medical deductions or State and local taxes, which at least in my State are not considered voluntary, although in theory I could move to Alaska (e.g.) and avoid them.

Whatever one makes of the theory, the Obama proposals will make for some very interesting political bedfellows. Medical deductions being limited to those in excess of 7.5 percent of AGI (and not covered by insurance), the most important itemized deductions tend to be those for home mortgage interest, State and local taxes, and charitable contributions. The deduction for each of these items benefits the taxpayers but also the recipients of their funds, who in at least two cases (tax-exempt charities and the housing industry) are currently on their derrieres thanks to the economic crisis and (for many charities) the antics of Bernie Madoff, who liberated them of much of their cash right as the crisis began. The charities and high-tax states (California, New York, etc.) that benefit from itemized deductions are, moreover, frequently liberal in orientation, the kind of people Obama depends on for political support. By reducing the value of these deductions, he is thus--to use the language of tax expenditures--essentialy cutting spending on economic sectors that are both economically depressed and politically sympathetic to him. Depending on one's viewpoint, this may demonstrate either his political courage or naivete; but it certainly makes things interesting.

One interesting wrinkle: many of the people who would be hit by this proposal are already paying higher taxes under the AMT (alternative minimum tax), which treats some, but not all, itemized deductions as preference items. While making Obama appear perhaps less cruel than he would otherwise, this also reduces the likely revenue impact from his proposal. But that is for another column.