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Slashing deductions: the right way to fix U.S. taxes

President Barack Obama walks away from the podium after making a statement in the Rose Garden of the White House in Washington, Monday, Sept. 19, 2011.

Susan Walsh/AP

Forget the Buffett Rule – the latest White House idea to set a minimum tax rate for the richest Americans. President Barack Obama's simpler proposal to cut tax deductions could, if pushed, go a long way toward eliminating the U.S. deficit. And unlike the Buffett Rule, which though still vague would surely involve new taxes, there's even a hint of common ground with the Republicans on deductions. Best of all, killing off what policy wonks call tax expenditures would in many cases do little economic harm.

The biggest tax deductions currently allowed – a list headed by medical insurance costs and mortgage interest – will cost the Treasury some $4.5-trillion (U.S.) in forgone revenue between 2012 and 2016, according to the 2011 budget. That suggests that if these deductions were eliminated altogether, federal revenue would rise by more than $9-trillion over the typical 10-year budget horizon, ignoring second-order effects. That exceeds the Congressional Budget Office's current forecast, on realistic policy assumptions, of a 10-year cumulative deficit of $8.5-trillion.

It's not feasible to go the whole hog, though. Eliminating all deductions would hit the middle class, who benefit substantially from the deductibility of health insurance contributions, for example – even though that deduction also distorts the market for health care. Furthermore, some deductions, such as those allowing tax-free contributions to retirement plans, are valuable because they encourage saving in general and for retirement in particular.

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Mr. Obama's plan goes only a small part of the way, allowing deductions at a reduced 28-per-cent rate rather than the current top rate of 35 per cent. It could raise $400-billion over 10 years, even limited to relatively high earners. GOP House Speaker John Boehner has not ruled out such moves, although Mr. Obama's plans have met opposition from some Republicans.

If the political gap could be closed, there would be economic advantages to going much further. For example, the current deduction of mortgage interest – worth $600-billion over five years – provides an incentive for wasteful investment in McMansions and benefits the rich most because of their larger mortgages and higher marginal tax rates. The charitable tax deduction, meanwhile, encourages not only useful donations but also those that may benefit the donor's ego rather than the notional recipients. As a way to reduce the deficit, slashing the right deductions has considerable merit.

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