Preview of the Coming Tax Wars

The Bush tax cuts are scheduled to expire at the end of the year. Barack Obama has repeatedly said he wants to extend the cuts for 98 percent of households, or those making less than $250,000. If he gets his wish, that's just the beginning of the story.

The White House is considering "limiting an extension of the popular middle-class tax cuts to a year or two," according to the New York Times. Why? First, they want to shrink the deficit projections. Second, Democrats expect to overhaul the tax code before 2012.

Both parties know that a showdown over tax law is brewing, and Washington lobbyists can smell the brew. In the short term, the battleground will be the Bush tax cuts. Republicans will argue that you can't roll back tax cuts (that is, raise taxes) on upper-middle class earners during a slow recovery. Democrats will argue that we're a safe distance from the recession, the federal coffers are starving for more revenue, and returning the top marginal rates to their 2000 levels to capture $678 billion of revenue until 2020 is a justifiable corrective at a time when the top five percent of earners take home the highest share of total income in more than five decades.

Act One will be tax cut rollback. Act Two will be tax reform. What will that look like? Many experts expect a value-added tax might appear to help offset reductions in income, payroll or corporate taxes. Others expect broad, tax-neutral reform along the lines of the Wyden-Gregg tax simplification plan (read about some of its features here). The theme coming out of sensible liberal and conservative corners is that we should broaden the base of taxable income in exchange for lower tax rates. But what does that even mean? Let's consider some examples.

Take the interest you might pay on your mortgage. Currently, taxpayers can deduct mortgage interest and property taxes on their homes. But this is a troublesome tax subsidy for a few reasons. It's regressive because most of the support goes to high-income households with valuable mortgage interests that are worth itemizing. It also encourages Americans to take on more debt, and we've seen where those kind of incentives can lead us. The Tax Policy Center analyzed what would happen if you eliminated the mortgage interest subsidy and cut all marginal tax rates by 1.8% to make it revenue-neutral. This chart explains how that base-broadening/rate-lowering swap would affect our after-tax income:

Mortgage deduction tax swap.png
Almost the entire top quintile sees less after-tax income, especially in the 90-99 percentiles. The bottom four quintiles would see their after-tax income rise. So despite cutting tax rates, broadening the tax base tends to be progressive, punishing the highest earners and benefiting the rest of us, right?

Not so fast. TPC also considered what would happen if we eliminated the three most valuable income tax expenditures on health care (the exclusion of employer-supplied insurance (ESI) premiums and medical care, the deduction for self-employed health plans, and the itemized deduction for medical expenses). Offsetting the larger tax base was achieved by slashing all marginal rates by 2.48%. Here's what the after-tax income picture looks like:

health subsidy.png
The outlook turns regressive. The folks in the second quintile get knocked the hardest. The top one percent wins out.

To sum up, revenue neutral tax reform that eliminates the mortgage deduction helps the middle class at the expense of the rich. Revenue-neutral tax reform that eliminates the health care exclusion hurts the middle class and enriches the top percentiles.

Why wade into these numbers anyway? It's important to remember that if tax reform rides into Washington on the promise of broad revenue-neutrality, that doesn't mean reform will be revenue-neutral for each quintile. Major tax reform that seeks to eliminate key deductions will benefit certain parts of society and cost others. In Act One, Republicans will holler about the ever-increasing tax burdens of the rich. In Act Two, it will get a lot more complicated.