Feldstein: Capping Tax Expenditures Is the Way to Raise Revenue

In a Project Syndicate piece, former Chairman of President Reagan's Council of Economic Advisors Martin Feldstein reminds us about another idea to raise revenue from tax expenditures. Instead of going through each preference and figuring out the best course of action, it might be effective--and potentially politically easier--to cap the overall benefits taxpayers receive from tax expenditures.

Here is an idea that might work politically: Let taxpayers keep all of the current tax expenditures, but limit the total amount by which each taxpayer can reduce his or her tax liability in this way.

I have explored the idea of “capping” the benefit that individuals can get as a percentage of their total income (their “adjusted gross income,” or AGI in US tax parlance). Applying a 2%-of-AGI cap to the total benefit that an individual can receive from tax expenditures would have a very powerful effect. It would not limit the amount of deductions and exclusions to 2% of AGI, but rather would limit the resulting tax reduction – that is, the tax benefit – that the individual gets by using all these special features. For someone with a 15% marginal tax rate, a 2%-of-AGI cap would limit total deductions and exclusions to about 13% of AGI.

Such a cap would have a significant impact on the fiscal outlook. Even if the cap were applied only to “itemized deductions” and the health-insurance exclusion, it would raise about $250 billion in the first year and about $3 trillion over the first decade.

There are many options in designing such a policy. The cap rate could be higher, or it could start higher and be gradually tightened, or it could vary with an individual’s income level. But the economic and political attractiveness of a cap consists in its ability to raise substantial revenue without eliminating specific tax expenditures.

It is a good time to revisit this idea, which was the basis of a paper by Feldstein, the National Bureau of Economic Research's Daniel Feenberg, and CRFB president Maya MacGuineas. While a standard application of the cap would have a flat distributional effect, the cap could be adjusted to achieve greater progressivity. Feldstein mentions a few ways to do this in the quotation above, but other possibilities could be to set a dollar limit, rather than a percent of income limit, or to couple the limit with an increase in the standard deduction.

Another way to increase progressivity would be to include other tax expenditures, such as capital gains and dividends, that tend to benefit high income earners under the cap or exclude some preferences that benefit lower income taxpayers. A paper from the Tax Policy Center investigated the distributional effects of a 3.9 percent of AGI cap that included both capital gains rates and certain deductions that generally benefit high earners. As the middle column in the table below shows, the overall effect would make the code more progressive.

^{Source: Tax Policy Center}

Ideally, lawmakers would examine each tax expenditure and determine the correct course of action.  However, this idea could be politically easier by not burdening one group of taxpayers over another to raise revenue. A tax expenditures cap could be a useful first step in addressing the many inefficiencies in the tax code. Whether we use this or another approach like that of Simpson-Bowles or Domenici-Rivlin, one thing is clear: we need more revenue to reduce our debt, and looking at tax expenditures should be part of the solution.