On tax rates
President Obama’s position in negotiations with Republicans on taxes and averting the fiscal cliff is to allow the Bush-era tax cuts to expire for households earning more than $250,000. The top income tax rate for taxpayers with higher incomes would return to the rate under Bill Clinton of 39.6 percent, a rise from the current 35 percent rate. Income tax rates for households earning less than $250,000 would remain unchanged. If Obama gets his way, it has been reported it would raise $850 billion over a decade.
A 39.6 percent top tax rate is apparently anathema to most Republicans in Congress. Compromise would seem to be in order.
Republicans have offered a willingness to consider revenue increases through the limiting or closing of itemized tax deductions allowed in the tax code.
But that skirts the issue. Obama wants higher tax rates on higher income taxpayers, while Republicans want no change in current tax rates. A true compromise on tax rates would split the difference. The middle ground would be a top tax rate of 37.3 percent. That would raise about half the revenue, $425 billion.
Through his press secretary Jay Carney, Obama has opened the door a bit to benefit cuts in entitlement programs like Social Security and Medicare, but many Democrats are resisting. Republicans insist that the root of the problem is projected spending increases and they want real cuts in benefits.
A compromise might be reached by agreeing to change the way Social Security benefits, other federal retirement programs and tax brackets are adjusted for inflation. The current inflation adjustment relies on the consumer price index. Many experts believe the CPI overstates increases in the cost of living because it fails to account for the ability of consumers to replace goods and services whose prices are rising faster with substitutes whose prices are rising more slowly. They believe what is called a chained CPI accounts for this ability to switch from higher priced goods to lower priced alternatives. The chained CPI rises on average about 0.3 percentage points more slowly than the measure now in use.
One estimate is that applying the chained CPI on all federal government indexed programs would reduce projected government deficits by $300 billion over the next 10 years.
Moving to a chained CPI for adjusting government programs and tax brackets for inflation can be viewed as a technical change that more accurately measures inflation. Democrats could take cover by emphasizing that aspect, and not view it as a cut in benefits in entitlement programs.
As Robert Greenstein, executive director of the Center for Budget and Policy Priorities said in an interview with NPR,
“You can view it as this is not a benefit cut.” He says we want to adjust for inflation. Let’s use the most accurate measure of inflation.
On the other hand, as Greenstein was quick to add, it will lower future Social Security benefits. The cuts will be very small at first and increase gradually over long periods of time. But Republicans would have got some of what they are after, some reform of entitlements.
On tax deductions
The Republicans are fond of reciting support of tax reform as opposed to raising tax rates. By this they mean eliminating some or the many deductions from income before those rates are applied to your tax bill. While favoring this route to revenue increases in theory, the Republicans have been far less specific on which deductions they would phase out. The grand daddy of all deductions is the tax break for mortgage interest. One estimate is that it costs the government as much as $100 billion per year.
Current law allows the deduction of interest paid on mortgage balances of up to $1 million dollars. It includes interest paid on mortgages for second homes and interest paid on up to $100,000 of home equity loans.
A compromise might be reached where the $1 million dollar cap could be lowered to something like $800,000 and deductions on interest on mortgages on second homes and home equity loans could be disallowed. This would capture a significant amount of the $100 billion annual revenue loss to the federal government.
So as not to disrupt the housing market too drastically, the changes would have to be introduced gradually. A formula could be devised whereby any changes to the deductions would not begin until 2015, and would gradually take full effect over a five year period. When fully effective, the goal would be to generate additional federal revenue of $500 billion over 10 years.
On defense spending
If the fiscal cliff is breached, on January 3rd the nation’s defense budget will be cut across the board by $500 billion over the next 10 years, and by about $55 to $60 billion in 2013 alone. In one report, Secretary of Defense Leon E. Panetta says it will be a disaster both for our nation’s defense and for communities with heavy defense installations and defense related industry.
Rather than using a meat ax approach to cutting defense spending the Project on Defense Spending advocates a more reasoned approach towards a more efficient defense budget. But even this study suggests cutting defense spending by about $400 to $500 billion over 10 years.
A good compromise that Democrats and Republicans might be able to agree on would split the difference, a cut in defense spending of something like $250 billion of 10 years. Even with these cuts, 10 year spending on defense would still amount to around $5.5 trillion.
Total savings could stabilize US debt
There you have it, a total reduction in federal debt of $1.725 trillion. It comes from additional government revenue of $925 billion – $425 billion from a higher top income tax rate plus $500 billion from modifying the home mortgage deduction; $250 billion in defense cuts; and $300 billion from using the chained CPI for inflation adjustments on benefit programs and tax laws, this being a split between lower spending and increased revenue.
This $1.725 trillion is very close to what one study estimates is needed to stabilize the ratio of federal debt to the nation’s Gross Domestic Product, an outcome that most economists would support as sufficient to solve any potential downsides from the debt. If need be, I’m sure responsible politicians could find the extra $75 billion in cuts or revenue to achieve that goal.
Tax free status of employer provided health insurance
If they can’t, here is a good candidate, modify the tax free status of employer supplied health insurance. One study suggests there is a lot of money there. Capping the amount of employer provided health insurance that is tax free could easily save the necessary amount.