Search This Blog

Monday, April 18, 2011

"Reduce spending in the tax code"

Last week (April 13, 2011), President Obama said, in his budget/fiscal policy plan speech, that one thing he wants to do is "reduce spending in the tax code, so-called tax expenditures. ... the tax code is also loaded up with spending on things like itemized deductions. And while I agree with the goals of many of these deductions, from homeownership to charitable giving, we can’t ignore the fact that they provide millionaires an average tax break of $75,000 but do nothing for the typical middle-class family that doesn’t itemize. So my budget calls for limiting itemized deductions for the wealthiest 2 percent of Americans -- a reform that would reduce the deficit by $320 billion over 10 years."

That line - "reduce spending in the tax code" was confusing to many. John Stewart puzzled over it, saying it was "code" for tax hike (4/14/11 on YouTube).

I'm not surprised - it does sound odd to think that there is spending in the tax code, but as I've posted here several times (such as 10/16/10 and 3/29/11), that is what special deductions, exclusions and credits that are not necessary for measuring taxable income, are. Instead of the government giving individuals a grant for home ownership, for example, you get a deduction which lowers your tax bill. What is odd about the "spending in the tax code" is that it doesn't work the same way a government grant would. A government grant would likely give more money to people with lower inocme. In contrast, a tax deduction gives more money to people with higher incomes (the higher tax bracket makes the deduction worth more to them).

And, when it comes to itemized deductions, only 1/3 of individuals itemize so 2/3 don't claim those deductions (medical, state taxes, charitable contributions, mortgage interest). They take the standard deduction instead.

President Obama has not talked about removing any itemized deductions or modifying any of them. Instead, he has proposed limiting their benefit to 28%. That still provides a significant benefit to high income taxpayers. He has not talked about other tax expenditures (outside of itemized deductions). I think serious tax reform to simplify and rationalize the system will require reducing the number of deductions, credits and exclusions - and lowering the tax rate. Generating funds to lower the deficit should also consider the spending in the tax code that doesn't need to be there.

What do you think?

8 comments:

RegCPA5963 said...

I think that it might be feasible to reduce or eliminate some deductions and tax credits. However, if you seriously reduced or eliminated the mortgage interest deduction how many individuals would just walk away from their homes. [I would have to consider it and my wife and I are more than double the median income in our area]. Reason being your home would be come a land-locked boat (hole in water, you just keep throwing money into).

Professor Nellen said...

RegCPA5963 - thanks for the comment. You raise a good point that many people do rely on the mortgage interest deduction to help in buying a home. And most people are not borrowing $1.1 million to buy a home so are not claiming a very large mortgage interest deduction.

As Congress and President Obama look to try to keep the 2001/2003 tax cuts without further increasing the deficit and debt, they will need to reduce tax expenditures. There is no reaon for the tax law to encourage debt on a second home or even home equity debt. I think these should be phased out, which would also bring some simplicity to the tax law and equity to borrowing decisions (for example, someone with equity in their home can borrow and deduct interest while others who might borrow with a credit card for the same purpose cannot deduct the interest and have to pay a higher interest rate too). I have heard some people say that the home equity interest deductions is to help with home improvements. Regardless of whether that is something the tax law has to subsidize, it is not a legitimate argument because borrowing for home improvements would produce deductible acquisition debt interest (it would only be home equity debt if the acquisition debt were already $1 milliom or more).

Brian Y - SJSU said...

I agree that reduction or removal of certain deductions, or “reducing spending in the tax code,” may be a positive alternative to raising the tax rate. According to the Tax Policy Center, “The mortgage interest deduction (MID) is one of the oldest and largest tax expenditures in the federal income tax and is the largest single federal subsidy for owner-occupied housing. The president's fiscal year 2010 budget reports that, in 2012, the MID will cost the federal Treasury an estimated $131 billion…” (http://www.taxpolicycenter.org/publications/url.cfm?ID=412099). While the home mortgage interest deduction is a popular deduction, one has to question if such a large subsidy towards home ownership is the best allocation of tax dollars.

Additionally, as you mentioned, the fact that the home mortgage interest deduction disproportionately benefits higher income individuals who are able to itemize their deduction affects the equity of the provision. According once again to the Tax Policy Center, “The MID disproportionately benefits taxpayers in the top fifth of the income distribution (Toder, Harris, and Lim 2009). Those who do not itemize deductions on their tax returns receive no benefit and the subsidy rate is larger for individuals in higher marginal tax rate brackets. Because most who benefit would own homes without the deduction, it mostly provides an incentive to live in more expensive homes, not to own instead of rent.” (http://www.taxpolicycenter.org/publications/url.cfm?ID=412099). As an alternative to the home mortgage interest deduction, what if the deduction was changed to either a credit or deduction towards housing expense that both renters and owners can take advantage of?

sandra peters said...

I agree with the elimination of home equity debta and second home interest deduction elimination. For aquisition debt interest elimination I think transition rules would be needed. There are many who purchased their home and are able to make the monthly payments due to the "tax subsidy". Banks may also have used the effective payment in their underwriting and may not have approved the loan without it. Removing it may put more mortgages as risk of default.

sandra peters said...

I agree with eliminating deductions for second home mortgage interest and home equity interest. However, any acquisition interest elimination if enacted should provide transition relief. Many homebuyers are only able to make their monthly payments due to the "tax subsidy". Lenders may have used the effective payment in underwriting criteria which may have otherwise disqualified many buyers Without transition rules, more home loans may be at risk of default.

sandra peters said...

I agree, interest deductions for a second home and home equity should be eliminated. However, if acquisition interest deduction is reduced or eliminated, there should be transition rules. Many home buyers rely on the "tax subsidy" to make their monthly payments through reduced payroll withholding. Lenders may also have used the net payment amount for underwriting criteria that may have otherwise disqualified the buyer.
Changing the rules for existing homeowners may put more mortgages at risk of default.

sandra said...

I agree, interest deductions for a second home and home equity should be eliminated. However, if acquisition interest deduction is reduced or eliminated, there should be transition rules. Many home buyers rely on the "tax subsidy" to make their monthly payments through reduced payroll withholding. Lenders may also have used the net payment amount for underwriting criteria that may have otherwise disqualified the buyer.
Changing the rules for existing homeowners may put more mortgages at risk of default.

sandra peters said...

I agree, interest deductions for a second home and home equity should be eliminated. However, if acquisition interest deduction is reduced or eliminated, there should be transition rules. Many home buyers rely on the "tax subsidy" to make their monthly payments through reduced payroll withholding. Lenders may also have used the net payment amount for underwriting criteria that may have otherwise disqualified the buyer.
Changing the rules for existing homeowners may put more mortgages at risk of default.