First Person: A Modest Proposal to Avoid Going Over the Fiscal Cliff

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COMMENTARY| A recent post by Dylan Matthews at WonkBlog on the Washington Post website (http://www.washingtonpost.com/blogs/wonkblog/wp/2012/11/14/let-them-eat-nonrefundable-credits/) sets forth what I believe is a very interesting proposal for how to resolve some of the "fiscal cliff" tax issues currently being discussed by President Obama and members of Congress. Instead of capping deductions for high-income taxpayers, as was suggested by Mitt Romney during the campaign, this proposal would allow a tax credit rather than a deduction, with the credit set at a fixed percentage of the currently deductible expense. Thus, if the credit was 20% for charitable contributions, any taxpayer making a $100 contribution would be allowed to take $20 (20% of $100) off his taxes.

I think that this proposal is promising because it has significant advantages that could appeal to both sides, including the following.

Fairness

This tax credit proposal treats all taxpayers the same, making it fair and evenhanded. If a 20% credit were allowed for charitable contributions, a taxpayer making a $100 contribution would receive a $20 tax credit, no matter what his tax bracket. As a result, in dollars, that contribution would be worth the same to all, rich or poor, unlike the current system where a $100 contribution reduces taxes for a taxpayer in the 10% bracket by $10, but by $35 for one in the 35% bracket.

Simplicity

The tax credit structure would be easy to understand and its tax effect would be easy to calculate, making it straightforward for taxpayers who want to estimate the tax value of specific expenditures. It also would be easy to implement.

Maintains Incentives

One of the ideas being floated to reform the tax code and wring more tax dollars from the wealthy is to limit tax deductions to a flat amount, such as $20,000 per year. One effect of this approach would be to eliminate the tax incentives to make some deductible expenditures, such as charitable contributions, once a taxpayer hits his annual limit on deductions. This could be devastating to charities that rely on donations to accomplish their missions. However, allowing a tax credit that is a fixed percentage of a deductible expenditure sidesteps this problem since there would be a tax benefit on every incremental dollar spent or contributed.

Potential to Be a Big Revenue Raiser

A tax credit on deductions could generate a lot of revenue by reducing the tax benefit of deductions, especially for those in the highest tax brackets. For example, if the tax credit for charitable contributions is set at 20%, the tax benefit from that deduction would decline for any taxpayer with a marginal tax rate of more than 20% (and increase or stay the same for those with marginal rates equal to or lower than the tax credit percentage). Thus, the tax bill for a taxpayer who is in the 35% tax bracket and makes $10,000 in charitable contributions would be $3,500 lower if these contributions were deductible, but only $2,000 lower if they generated a tax credit of 20%. It would be relatively easy to set the credit percentage at a level that would bring in more revenue from high earners than is lost from low earners.

Rates Can Stay the Same

One sticking point for Republicans in tax negotiations is their reluctance to raise rates on anyone. The beauty of the tax credit on deductions is that it could generate incremental revenue without touching rates since, as described above, it would automatically reduce the tax benefit of deductions for those with high taxable income, even at current tax rates.

It also would achieve President Obama's goal of increasing revenue from higher income taxpayers, since, depending on the tax credit rate, they would be likely to pay more than at present, as detailed previously.

In this respect, it could be a win-win politically for both sides.

I'm sure there are disadvantages to this proposal as well, but I believe that the advantages I've detailed make it well worth considering as part of the discussion about how to avoid going over the "fiscal cliff."

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