Right Opinion

The Deduction Cap Trap

Why the economic consequences could be dire.

Arnold Ahlert · Nov. 29, 2012

Over the last few years, the most prevalent adjective used to describe the economy has been “unexpected.” Unfortunately, it has almost invariably described an economy that was getting worse, as the nation has experienced the slowest and most anemic recovery on record. As negotiations continue in order to avoid the combination of tax increases and spending cuts scheduled to kick in at the end of the year, one of the ideas gaining popularity among both parties is capping many of the current tax deductions Americans use to reduce the amount of their taxable income. Yet certain caps, such as those on home mortgage deductions, state taxes and charitable giving, could produce one of the most unexpected results of all, namely a severe recession, or even a depression.

One of the most discussed deductions on the table is the mortgage deduction. A cap on mortgage deductions might be politically construed as tenable, due to its populist undertones: it only affects those with enough wealth to own a home. Furthermore, it tends to benefit upper-middle class families the most, according to the Tax Policy Center. They reveal that those earning more than $250,000 a year realize an annual tax savings of about $5,460 on average, while those with annual incomes of less than $40,000 a year save only $91. Since President Obama ran–and won– due in large part to dividing Americans by class, and Republicans have expressed an interest in tax code “reform,” this particular sacred cow may be headed for the proverbial slaughterhouse.

It might take the American economy with it. Here’s how the New York Times characterized the importance of the housing sector earlier this year: “Housing has blown a giant smoking hole in the middle of our economy, and the consequences continue to impede the pace of recovery.” That may be an understatement. Although the housing market has begun a tentative recovery, with the Standard & Poor’s Case-Shiller index showing nationwide price gains averaging 3.6 percent in the third quarter of 2012, those gains must be measured against the reality that median home prices have plunged nearly 40 percent since the beginning of the downturn. And despite gains that have lifted more than one million homeowners “above water,” meaning the value of their homes is greater than the mortgage they owe on them, 10.8 million borrowers still had negative equity in their homes as recently as June.

Furthermore, as many Americans have experienced firsthand, a decline in home values has a cascading effect. The housing crash obliterated much of Americans’ overall wealth. That in turn wiped out their ability to borrow or spend money. Depressed borrowing and spending levels led to massive job layoffs that further impeded borrowing and spending – which in turn led to an even further decline in home prices, as fewer and fewer Americans could either afford to buy a home, or were unwilling to risk buying one in an unstable job market. The collapse in home values led directly to millions of foreclosures, as Americans were either unable or unwilling to make their mortgage payments, saddling lending institutions with massive amounts of non-performing assets that precipitated the banking crisis. That in turn led to a massive bailout, courtesy of the American taxpayer.

Are Americans prepared for a reprise of that debacle? "Doing anything to further chill the housing sector will retard the nascent recovery that we’re in right now,“ said Jerry Howard, chief executive of the National Association of Home Builders. While the increase in tax revenue derived from the elimination of the home mortgage deduction would be borne mostly by those with more expensive homes, aka "the rich," the top 2 percent of income earners also produce over 30 percent of U.S. consumer spending, with the top 5 percent accounting for 40 percent of it. Thus, the effort to target those homeowners would likely re-ignite the vicious cycle outlined here. That cycle caused the worst recession since the Great Depression. A new downturn could put the nation in an unprecedented decline.

Caps on the deductions high-earning Americans currently take on their state taxes might best be described as progressive chickens coming home to roost. For years, states with the highest overall tax burdens, such as Illinois, New York, California, and New Jersey, have been progressive strongholds, and once again, they were solidly blue in the 2012 election. Yet the impact of those higher-than-average state taxes has been largely blunted by the reality that they can be subtracted from one’s overall income when calculating one’s federal tax burden. If those deductions were capped, many upper-middle-class filers wouldn’t be able to write off much of that burden. A higher overall tax burden means less disposable income, which in turn leads to less consumer spending, and the aforementioned vicious cycle begins anew.

Moreover, there is a cascading effect in play here as well. The New York Times offers a vivid illustration: "New York’s biggest investment houses are shifting jobs out of the area and expanding in cheaper locales in the United States, threatening the vast middle tier of positions that form the backbone of employment on Wall Street,” says the paper, before getting to the bottom line: “The shift comes even as banks consider deeper staff cuts here, which could undermine the state and city tax base long term.” Translation: higher-income Americans – and their jobs – have mobility, a reality borne out by the 2010 Census. It reveals people are migrating to states with low, or no income taxes. As more higher-income jobs leave high-tax states, the burden to fund state tax bases would fall on those remaining behind, as in those who are less mobile, meaning the middle class and the poor. Capping state tax deductions would exacerbate this reality.

The Wall Street Journal contends  this “would create political pressure to cut state taxes.” That is utter nonsense, at least in the short term. Take California. On November 6, the electorate in that state voted to raise state taxes by a convincing 54-46 percent margin, upping the state sales tax by one-quarter-cent for four years, and increasing income tax rates for those earning more than $250,000 a year, for seven years. Progressives and their enablers insist that the increases will bring an additional $6 billion a year into state coffers for the seven years these “temporary” tax increases remain in effect.

The Weekly Standard offers a reality check to such pipe dreams. California, “once a prosperous industrial and high-tech powerhouse and magnet for immigrants from elsewhere in the country, has transformed itself into something else: a high-tax, high-spending, highly regulated, and chronically broke welfare state that is fast losing to out-migration both its middle class and the businesses and industries that create jobs.”

California has long been considered the nation’s “leading edge” state. If state tax deductions are capped, California could conceivably buttress that reputation: it may be the first state in the nation to declare insolvency.

If states begin to declare insolvency? Since states can’t declare bankruptcy the federal government would be forced to step in and put the state into receivership – meaning American taxpayers from every state, including fiscally responsible ones, would be on the hook for their profligate brethren. Thus, Americans may yearn for the day when the only “too big to fail” entities they were forced to bail out were financial institutions. Those bailouts caused a deep recession. Bailing out entire states would destroy the economy.

Capping the amount of tax deductions one can take from donating to charity is another reform Congress is considering. According to a research paper by Joseph J. Cordes, an economics professor at George Washington University, “the tax deduction for charitable contributions is among the largest in terms of its estimated revenue impact,” he writes. “The Joint Committee on Taxation (2011) has estimated the five-year revenue cost (from 2010-2014) at just under $246.1 billion, and the charitable deduction has routinely been among the top 10 to 15 federal tax expenditures in terms of its revenue cost.”

The Charitable Giving Coalition, representing large nonprofit organizations, reveals that 33 percent of all donors said they would reduce their giving if the deduction was eliminated. That number climbs to 40 percent among donors ages 40 to 59, who represent key giving groups. They urge the government to leave the deduction intact. "America’s economic recovery requires a strong philanthropic sector, whose role as an investor in innovation and supporter of safety net services is more important than ever for a faster, sustainable economic recovery,“ they write, even as they warn that "any cap or limitation on charitable deductions undermines charitable giving and would have long-lasting negative consequences.”

Yet once again, the argument for eliminating the charitable deduction can be characterized in populist terms. CNN Money frames it as “unfair” because it is an itemized tax deduction, and 70 percent of American taxpayers don’t itemize. Furthermore, those in a higher tax bracket get to write off a higher percentage of the money they donate. Thus, CNN claims, giving “the rich” a bigger incentive to donate gives them “greater control over the country’s charitable giving.” Yet even CNN is forced to admit that since the charitable deduction “has experienced little disruption since it was created in 1917, we cannot be absolutely sure what would happen if it were eliminated or cut.”

Currently there are calls, such as the one made by the Washington Post editorial board, for capping all itemized deductions. Yet the Independent Sector, a network for nonprofits, foundations, and corporate giving programs, reveals some of the consequences of such caps with respect to charitable giving, noting that those who itemized their deductions accounted for 70 percent of the $229 billion in charitable donations in 2008, with 2 percent of taxpayers in the top bracket accounting for 33 percent of all charitable giving that year. They estimate that eliminating the deduction completely would depress charitable giving by 25 to 36 percent. Even just capping donations under the current proposals (the president is proposing a 28 percent cap) would reduce charitable donations by $7 billion per year. Either way, many charitable organizations would likely take a serious hit, or be forced to curtail charity work completely.

Yet there is also an aspect of capping charitable donations that is rarely discussed: the effect on the character of the nation. There is a tremendous difference between money that is donated freely, and that which is confiscated through taxation. There is no way to quantify the real effect of reducing the former in order to increase the latter. Yet human nature suggests that the more Americans are made to feel beholden to our ever-expanding welfare state, the less likely they will feel the spirit of generosity that has been a quintessential part of the American character. If “let the government take care of it” becomes the prevailing attitude – and it is already the political philosophy that forms the essence of the American left – the consequences for charities, as well as the economy in general, could be profound.

All of the above caps, or in turn, the scheduled increase in taxes outlined here that would take place if no deal is reached before December 31, center around one idea: increasing the amount of revenue taken in by a federal government that currently borrows forty cents of every dollar it spends. Yet every dollar that is spent by government is a dollar that cannot be spent in the private sector. Furthermore, when Bill Clinton left the presidency in 2000, federal spending stood at $1.9 trillion, heading into FY 2001. On February 1, 2010, Barack Obama revealed a $3.8 trillion budget for FY2011. Thus, in a single decade, federal spending doubled! Furthermore, FY2013 is off to an inauspicious start: federal spending has increased in the first month of the year by 16 percent over the first month of FY2012, even as tax revenues increased 13 percent. In other words, despite more money coming in, spending still outpaced increased amounts of revenue.

Again, virtually all of the details outlined here, as well as countless others that will enter into the discussion about raising government revenue, miss the point entirely. America doesn’t have a revenue problem, it has a spending problem. Yet, remarkably, other than the automatic spending cuts that would kick in as a result of sequestration – none of which address the prime drivers of America’s debt and deficits, other than military outlays – there are no serious proposals for reducing a level of spending on entitlements that is driving this nation inexorably towards bankruptcy.

Until serious, long-term spending reductions on such entitlements are phased in, nothing is likely to alter our date with destiny. Capping deductions is nothing more than delaying the inevitable – at best. At worst, they will engender another recession or depression. Such tax code “reform” may make the politicians in Washington D.C. feel good about themselves. The rest of America? Not so much.

Arnold Ahlert is a columnist for FrontPage Magazine.