Reilly and Solomon on 28% Cap

I want to highlight a terrific article published by Mary Anne Reilly and Martin B. Solomon in yesterday's Tax Notes. See "Sophistry Supporting Complexity: The 28 Percent Deduction Limit," Tax Notes, Nov. 21, 2011, p. 1019.

I'm a big fan of examples in tax articles and reports. Reilly and Solomon provide good examples that illustrate something I've been saying for months. Team Obama is unable or unwilling to articulate a coherent tax policy agenda. The Obama administration sometimes articulates principles that resonate with the political left and the political right. But the principles always degrade into populist mish-mash when translated into specific legislative proposals.

Background

In September, President Obama launched his 2012 re-election campaign by proposing a $447 billion new stimulus measure (ahem, "jobs plan"). With a 9% national unemployment rate, Obama will be facing headwinds in the next election. He decided that he might be able to save one job (his own) by deflecting criticism to "obstructionist" Republicans.

We are running deficits as far as the eye can see. As partial funding for the new stimulus measure, the Obama administration proposed a 28% cap on certain deductions and exclusions. The specific proposal begins on page 137 of this PDF (page 134 of the report). The new cap is projected to raise approximately $400 billion. It's unclear how the new cap would apply if the 2001-2003 temporary individual tax discounts (the "Bush tax cuts") expire in 2012.

Howard Gleckman at Tax Vox reacted to the proposed cap as follows:

An across-the-board cap on the benefit of deductions and the like is often seen as rough justice — a way to tackle the Revenue Code’s trillion dollars in tax expenditures without fighting over each one. The theory: It is an easier political lift to curb such popular breaks as the mortgage interest deduction through a broad reduction of all subsidies than to fight the powerful housing industry head-on.

But Obama does pick and choose the preferences he wants to target. He nails all itemized deductions, all right, but he also goes after some – but not all – above the line deductions. Of the roughly two dozen write-offs available to those who take the standard deduction, Obama targets just eight, including health insurance for the self-employed, medical savings accounts, health savings accounts, and some higher education expenses.

He also reduces the benefit of two other hot-button breaks — the tax exclusions for municipal bond interest and the value of employer-sponsored health insurance. In other words, for those making more than $200,000, some muni bond interest and some of the value of their medical coverage would be taxed.

However, Obama would protect other exclusions, including those for retirement savings. Picking winners and losers this way is likely to defeat any claims of rough justice and make passing the plan that much tougher.

Sophistry, Complexity and Inequity

Reilly and Solomon criticize the 28% Cap Proposal on three grounds.

First, they argue that it represents politically-motivated sleight of hand. I'm not going to dwell on this argument. I believe that we should eliminate tax expenditures directly, not limit tax expenditures through complicated and unfair caps and floors. All variations of the 28% cap represent political expedience, not good tax policy.

Second, they argue that the "complexity created by separating the tax cost of income from the tax benefit of deductions is quite significant." Ironically, the "principles for tax reform" outlined by Obama in his recent message to Congress include "a call for simplification." The 28% Cap Proposal goes in the opposite direction. Do we want simplification? Or do we want to induce migraine headaches for tax preparers? You decide. The 28% Cap Proposal would require:

[A] computation of the tax on a new item called adjusted taxable income (ATI); a determination of another new item, the minimum marginal rate amount (MMRA); computation of tax on the greater of taxable income or the MMRA; and a computation of the "additional amount," which is the excess of the tax on ATI over the greater of the tax on taxable income or the MMRA, plus 28 percent of the excess of ATI over the greater of taxable income or the MMRA. This last number represents the additional tax generated by the new 28 percent deduction limitation.

Third, they argue that the "proposal is loaded with potential inequities and questionable tax policy." Most important, the new rules would have a cliff effect. They would be "triggered on an all-or-nothing basis when a taxpayer's adjusted gross income is above $250,000 for a joint return and $200,000 for a single taxpayer," potentially resulting "in an enormous addition to tax as a result of as little as $1 of additional income."

Reilly and Solomon provide an example of a family (the Cliff Family) with two parents and two children. The example compares the tax liabilities of the Cliff Family assuming AGI of $250,000 and $250,001, respectively. The authors hold other numbers constant to demonstrate the impact of the 28% Cap Proposal. Based on "middle of the fairway" assumptions, the authors demonstrate that $1 in additional salary income to the Cliff Family would trigger a $5,708 incremental tax liability.

The political left has vehemently argued that the "wealthiest" taxpayers are not paying their "fair share." The Obama administration has consistently defined "wealthy" taxpayers to include a family with $250,001 of taxable income. Does a $5,700 tax liability on $1 of incremental income satisfy the administration's definition of "fairness"? Is there someone on the political left creative enough to defend the "fairness" of the cliff effect? I'll stay tuned for that development.