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If the GOP is going to raise taxes by limiting deductions, here’s one way to do it that would result in the least damage

As Erick explains in today’s featured story, “Reasonableness,” it appears that Boehner and McConnell are prepared to give in and agree to raising revenue by limiting deductions. The premise is that this is less likely to impact small businesses (the job creators) than raising rates.

This is correct. However, we can’t ignore that limiting deductions will have a significant effect on many middle class taxpayers. Before the GOP goes down this road, I hope they will consider how to do this in the least harmful and intrusive manner. For to pretend that this will NOT impact the middle class is a complete lie. A great many middle-class taxpayers will be hurt. I’m thus presenting one possible methodology here for comments.

First, some quick background data.

Every taxpayer gets a standard deduction, if they do not itemize on their return. This then, is their “floor.”

For the overwhelming majority of middle class filers who itemize, their deductions consist of the following: mortgage interest, real estate taxes, state and local income taxes, and charitable contributions. It’s much harder to deduct medical expenses, though some still are able to do so, and there are also the few job related and miscellaneous deductions that some can take.

There are valid arguments for limiting deductions that can, and should, appeal to conservatives. This is because giving preference to certain expenditures skews behavior; it lets government use the tax code to influence the public’s actions.

Let’s briefly discuss the three most common deductions:

1. Mortgage interest and real estate taxes: These were put in place to subsidize the American dream of home ownership. I believe this is a worthy goal. There are some proposals to allow these for only one home, the primary residence, and possible cap the interest deduction on these mortgages to a maximum of $300,000 principal amount.

2. State and local income taxes: Taxpayers living in states with no income tax are in effect subsiding those who vote for high state income taxes (predominantly “blue” states) as being able to deduct these from the federal return results in a not-inconsiderable savings. We can be assured that blue state congressmen will do everything possible to keep this in place.

3. Charitable giving: Obama philosophically wants to curtail this, as he would like to see big government as the source of all benefits for its citizens. I suspect that the vast majority of conservatives would continue to donate at the same rate, but they will obviously feel the cost of doing so.

Instead of “tweaking” these components, why not allow people to act according to their own inclinations and preferences. Since the standard deduction is a “floor,” why not just have a “ceiling” for itemized deductions. Maintain them exactly as they are, just cap the amount in total that can be taken.

But here’s the real beauty of this approach. Do not express the cap as an absolute number, as is done now for the standard deduction. Rather, do so as a percentage of Adjusted Gross Income (AGI).

This treats everyone exactly the same. It is thus 100% “fair”

Here’s one way it could work:

For AGI’s of $50-100k, the cap on itemizing deductions would be 25% of AGI; from $100-150k, it could drop to 20%.

Thus, if your AGI is $80k, your cap for itemized deductions would be $20k. You calculate them as before. If they total $15k, that’s all you get to deduct. If they total $25k, all you can deduct is the $20k cap. It would also be possible to allow a phase in, perhaps over a 2-3 year period, for those find themselves exceeding the cap, to limit the impact.

Analysis of current income tax return data ( which is far beyond my ability) would allow us to determine the percentages and the brackets that would be “tax neutral” for the vast majority of taxpayers, and thus provide the least amount disruption, while still achieving the goals of raising revenue by limiting deductions.

Again, the two key advantages of this approach:

1. It’s the least intrusive, in that it does not attempt to skew behavior, and allows most taxpayers to act as before. Particular special interest groups, (i.e. realtors, or blue state congressmen) will find it much harder to preserve their own sacred cow.

2. It’s absolutely 100% FAIR. Everyone, I mean everyone, gets the same percentage of their AGI as a ceiling for their itemized deductions.

It also shows that the Republicans in Congress have not forgotten the voters who elected them in the first place.

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