Limit Tax Deductions for Lower Rates, Not Just Deficits

April 30, 2013

Feldstein Plan Scores on Revenue but Fails on Growth

Washington, D.C., April 30, 2013—Limiting personal tax deductions solely to reduce the deficit would slow economic growth, lowering the nation’s gross domestic product 73 cents for every dollar of new revenue raised, according to a new analysis by the Tax Foundation. A superior strategy would be to use deduction limits to lower marginal tax rates, either on their own or in conjunction with a long-term plan for deficit reduction.

The proposal to limit tax savings from itemized deductions, municipal bond interest, and employer-provided health insurance was first introduced by Harvard economics professor Martin Feldstein in 2011. The plan has gained greater interest since his recent op-ed in the Washington Post, in which he suggested that his plan could break the budget impasse in Congress and end the mandatory “sequester” budget cuts.

The proposal to cap itemized deductions at 2% of a taxpayer’s income in the name of deficit reduction has some advantages over other revenue-raising plans, but would ultimately do more harm than good to the U.S. economy and the federal tax code. Using additional revenue to lower marginal tax rates, or splitting the revenue between deficit reduction and lower rates, would create an economic boost that would provide a greater benefit to a greater number of Americans.

“Once the economy has adjusted to the new tax rules of the Feldstein plan, private business GDP would by fall by about one percent,” said Tax Foundation Fellow Dr. Michael Schuyler. “The smaller economy would have a negative feedback on tax revenues, taking away an estimated 15 percent of the money the deduction limits would otherwise collect.”

The same cap on deductions, however, could also finance a 17 percent, across-the-board cut in individual income tax rates. The Tax Foundation’s dynamic simulation model indicates the swap would stimulate the economy, with private business GDP growing 1.2 percent. At the same time, growth feedback effects would see federal revenues actually increase by $38 billion despite the reduction in rates.

Tax Foundation Fiscal Fact No. 366, “Feldstein Proposal Increases Federal Revenues but the Devil’s in the Details” by Dr. Michael Schuyler, is available online.

The Tax Foundation is a nonpartisan research organization that has monitored fiscal policy at the federal, state and local levels since 1937. To schedule an interview, please contact Richard Morrison, the Tax Foundation’s Manager of Communications, at 202-464-5102 or morrison@taxfoundation.org.

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