Orszag: Why plans to limit tax breaks may soon die

As negotiations over the fiscal cliff get down to details, they will become more arduous - something that financial markets seem to be ignoring. The superficial appeal of proposals to limit tax expenditures, for example, will fade as the details become clearer.

Whether the negotiators can navigate the obstacles and still get a deal done before Dec. 31 remains an open question. Automatic tax increases and spending cuts are scheduled to take effect at the beginning of January.

On their face, proposals to raise revenue by limiting tax breaks enjoy unusual bipartisan support - at least when they are described generically as "broadening the tax base and eliminating loopholes." Enacting legislation, though, requires much more than such platitudes, and therein lies the political difficulty.

Take the recent proposal to limit itemized deductions to a maximum of $50,000 a year. According to the Tax Policy Center, that would raise more than $700 billion over the coming decade, almost as much as the marginal-rate increases the Barack Obama administration is proposing for high-income taxpayers. Because median household income is also about $50,000, that level of allowable deductions strikes most people as extraordinarily generous, adding to its luster.

Perhaps more important, the proposal doesn't specify which deductions would be limited, but rather leaves that up to the individual. It thus reflects the new fundamental law of political economy: The vaguer the proposal, the better.

Let's take a closer look at the effects of such a limit, though. In 2009, according to data from the Internal Revenue Service, taxpayers who itemized their deductions and had incomes of more than $200,000 had average deductions of $50,000 or more.

For those with $200,000 to $500,000 in income, average deductions amounted to more than $51,000; from $500,000 to $1 million in income, the average was more than $100,000. At higher incomes, the averages rose further.

That households with incomes of more than $200,000 would be disproportionately affected by the deduction limit is neither surprising nor necessarily troublesome. Here comes the problem. In 2009, those taxpayers deducted more than $300 billion, 90 percent of which came from just three categories: taxes paid (mostly state and local taxes), home-mortgage interest and charitable contributions.

Of the big three, charitable giving is the most discretionary (unless a family moves to a smaller house with a smaller mortgage, or a city or state with lower taxes). The charitable sector thus has the most to lose from a limitation on itemized deductions.

How much money is involved? In 2009, households with incomes of more than $200,000 claimed almost $60 billion in charitable deductions - or about 20 percent of total charitable giving in the United States that year. Households with incomes of more than $10 million claimed an average of $1.75 million each in charitable donations in 2009, and they accounted for roughly 5 percent of all giving.

Charitable giving reacts to tax incentives, and in response to any limits on deductions it could even fall by about the same amount as the increase in the tax bill, according to John List of the University of Chicago, who recently reviewed the literature on this subject. Other studies have suggested an effect about half as large. Even that smaller estimate, though, suggests that limiting deductions to $50,000 a year could easily reduce giving by tens of billions of dollars.

How long do you think it will take the charitable sector to figure this out? This is just one way in which the $50,000-limit idea is likely to become less politically attractive. In addition, there are important questions about the proposal's design. For example, above the $50,000 limit on deductions, the tax incentive disappears. Below that threshold, though, the per- dollar tax break would still be tied to the individual's marginal-tax rate. As I have written before, it would be fairer and more efficient to replace a wide variety of deductions with flat-rate credits.

What's more, evidence suggests that charitable giving would be higher if the tax incentive took the form of a matching credit (which goes to the charity) rather than a rebate (which goes back to the individual). So rather than curtail the tax deduction for charitable giving indirectly, through a $50,000 limit on all itemized deductions, it would be far better to replace the existing deduction with a flat credit that would go to the charity.

Under this approach, if someone gave $1 to a charity, the government would also contribute, say, 15 cents more to that charity in the form of a matching tax credit. (It may be necessary for both constitutional and policy reasons to exclude religious organizations from this matching credit. Such organizations could, though, continue to benefit from a simple flat-rate tax credit that takes the form of a rebate, as with the existing structure.) The tax subsidy per dollar of charitable giving would no longer depend, as it does today, on the individual's marginal-tax bracket.

The bottom line? The legislative process will soon reveal the flaws in vague, simplistic strategies to limit tax deductions. If we are going to put in the effort to reform the tax code, we should at least try to do it right.

Peter Orszag is vice chairman of corporate and investment banking at Citigroup and a former director of the Office of Management and Budget in the Obama administration.