Republicans have been tripping over one another to slag President Obama’s tax proposal, made in his State of the Union address, to repeal the step-up in basis on inherited wealth and use the revenue it would generate to increase the child tax credit and pay for free community college. While it’s almost Pavlovian for Republicans to attack any Obama tax proposal, this one actually contains the seeds for a radical tax reform that would be much more conducive to economic growth than anything currently on Paul Ryan’s desk.
Rather than merely dismiss the president’s proposal Republicans should see it as a signal that President Obama has discovered that the tax code has regressive aspects to it, and he wants to fix precisely one of those regressive provisions and use the savings from doing so to fund a modest tax cut and a new education initiative.
They should call his bet and raise it. If he were to propose repealing a few other regressive tax breaks it could generate trillions of dollars of new revenue that both fund various projects and allow for exponentially greater tax cuts for the middle class.
What other upper-class tax breaks be eliminated? It’s easy: Three of the biggest are the deduction for state and local taxes, mortgage interest, and employer-provided health insurance. Together, these add up to nearly $400 billion a year, dwarfing the revenue lost from the step up in basis on inherited assets. They are also terribly regressive, with nearly all of their benefits going to people in the top quintile of the income distribution. Roughly two-thirds of all taxpayers don’t even itemize on their 1040, meaning they get nothing from these deductions.
Not only are these tax breaks regressive but they do nothing for growth—quite the opposite. The mortgage interest deduction siphons capital from more productive investments into bigger houses. The health insurance deduction results in wasteful spending by people with gold-plated insurance. And the deduction for state and local taxes effectively subsidizes state spending. Each one effectively harms the economy.
Using this revenue to lower tax rates across the board would be a unalloyed boon for the economy: the high implicit tax rates low-income earners face when they begin earning enough for their benefits to start phasing out could be addressed, as well as the effective 50 percent marginal rates so many small business owners face in high-tax states.
If the president—backed by the Democratic leadership in the House and the Senate—declared his desire to repeal these tax provisions it could immediately change the political calculus for tax reform. The Republican tax-writers—Paul Ryan and Orrin Hatch—are so anxious to jettison these completely unproductive tax expenditures and use the revenue to lower tax rates that the Democrats would be able extract concessions from them. A doubling of the gas tax? Absolutely. Funding for free junior college tuition for all? Done. And if they acquiesce to dynamic scoring, such a move would produce even more revenue gains, so they could up their demands even more—a bigger child tax credit and more money for infrastructure would be just the start.
Of course, no one should hold their breath waiting for such bold initiatives from the White House. The reason no one dares dares to remove these tax expenditures is that they happen to be very popular, and taking on any one of them is politically risky. John McCain saw this first hand when he took on what had been heretofore a Democratic initiative to effectively cap the deductibility of employer-provided insurance in his 2008 campaign and watched Barack Obama crucify him over it.
The other hurdle to Democrats proposing to get rid of these regressive tax expenditures is that they overwhelmingly go to their constituents. State and local taxes are much higher in states like New York, California and other blue states with high incomes and generous governments. The benefits of the mortgage interest deduction also go overwhelmingly to blue state denizens—the average per-household benefit from this deduction is ten times higher for the suburbs of New York and San Francisco than for those residing in places like Peoria, Illinois. Given that the deduction is all but worthless in actually achieving its ostensible purpose of helping people afford houses, it's hard to see it as much of anything other than a transfer from the middle class living in red states where housing is affordable to the wealthy blue state homeowners.