Tax Reform Still Needed, But Not As Outlined in Obama’s Budget Proposal

I reported last year that my tax returns and supporting worksheets were 297 pages. This year they were 308 pages. We have not had tax reform in the last year (though we’ve had increases in some tax rates). Tax reform is still desperately needed.

The income tax has become a part of the modern economy. I don’t have a philosophical objection to income taxes per se. But I believe in lower tax rates, fewer loopholes, and broader participation by the citizenry.

Every choice made to tax some things and not tax others skews people’s decision-making. They will seek more of what is not taxed, and less of what is taxed. For example, not taxing employer health insurance means more people want health insurance through work, rather than individually purchased insurance. As another example, permitting deductions for mortgage interest means people seek home ownership and mortgages. In the absence of the tax laws, people might choose to rent a home rather than buy.

presidential sealThe decisions on what to tax also show philosophical differences between politicians. President Obama’s recent budget proposal is an example. I disagree with two of the choices he has made – the limitations on the deductions that upper income Americans can take when they itemize deductions on their tax returns, and the lifetime limitations on contributions to 401(k) and other retirement plans.

The rest of this post discusses the limitations on itemized deductions. Next week I’ll cover limitations on retirement plan contributions.

The major categories of itemized deductions on Schedule A are medical expenses, state and local taxes, home mortgage interest, and charitable contributions.  The rationale for limiting these deductions is that taxpayers in higher tax brackets get a bigger percent deduction than middle income taxpayers.

Here’s what will happen if upper income taxpayers are limited in what they can deduct on Schedule A:

  • 1.      Medical expenses

In past years, deductions for medical expenses have been limited to those expenses that are over 7.5% of income. Congress has already passed legislation increasing that limit to 10% in 2013. This means that higher income Americans have to incur much higher medical expenses than other taxpayers before they get any deduction on their Schedule A.

Now the President wants to limit them to a 28% deduction, instead of a higher percent if they are in a higher tax bracket. This means that not only is their threshold higher, but they won’t get a deduction for the full amount they paid.

The Affordable Care Act has already put other taxes on this group of people. Has anyone in the Administration stopped to think about the total tax impact of the ACA on this group of citizens and whether it is the right level of taxation for healthcare?

  • 2.      State and local taxes

One could argue that when people choose where they live, they choose their state and local taxes, and that people can live if they don’t want to bear this tax burden. Still, taxpayers should be ready for double taxation on a part of their income – the states and municipalities will take their share, and with the Schedule A deduction limited, the IRS will take a part again. I would predict more people will leave high-tax states and municipalities if this proposal is passed.

   3.      Home mortgage interest

I actually think a limit on the home mortgage deduction is appropriate, though I’m not sure a percent limitation is appropriate. A dollar limit might be more appropriate.

And given that the real estate market is only just beginning to recover and home purchases and mortgages are long-term decisions, phasing whatever limit is adopted might be better than a sudden change. People can’t adapt to this change overnight.

  • 4.      Charitable contributions

This is the item in the President’s proposal that I disagree with most strongly, because I have a philosophical difference with the President. It seems clear that President Obama believes that the federal government should redistribute wealth in this country, and he wants to use the tax code to assist in that redistribution.

I believe that that Americans should not only decide themselves whether to give away their income, but also that they should be allowed to decide where to give it. If I want to make charitable contributions to a local hospital and my neighbor wants to support a museum, why should we not make these decisions? I do not think the government is better equipped to decide which causes to support than each citizen acting on his or her own beliefs.

Those like the President who disagree with me might say that Americans are still free to give to the charities they want to support. This is true, but as tax rates go up, taxpayers have less after-tax income to give. And if a taxpayer in the 35% tax bracket is limited to a 28% deduction, he or she will have to have $1.25 in pocket to give a dollar to charity. We will have less giving to charity, which is not the result I think this nation wants.

That’s my perspective on itemized deductions.

I also disagree with the President’s proposal limiting lifetime contributions to 401(k) plans. More on that next week.

In the meantime, I hope we can all agree that the tax code is too complex, and start supporting overall tax reform by both Republicans and Democrats. Probably no one will agree with all the changes made; there will be winners and losers. But if we can reduce the overall complexity, and hopefully reduce rates as a result (or at least not raise them), perhaps in the long run we will have a fairer system.

At least it won’t take 308 pages to complete a tax return.

Do you think Americans with higher incomes should face limits on their itemized deductions?



Filed under Law, Politics

3 responses to “Tax Reform Still Needed, But Not As Outlined in Obama’s Budget Proposal

  1. I think it’s interesting that when income tax first came into being, it was never supposed to exceed 1% of a person’s income. How about a tax only on goods perchased?

  2. Pingback: Obama’s Plan to Cap Retirement Savings — How Much Is Too Much Income or Too Much Taxation? | Sara Rickover, Behind the Corporate Veil

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