Toward a Smarter Tax Policy: Other Approaches to Deduction Reform

At a press conference last night, President Obama firmly restated his support for limiting mortgage interest deductability as well as the deductability of charitable giving. It is interesting to see, because even some Democrats are opposed to the plans.

Under current law, those in the 35 percent bracket reduce their taxes by 35 cents for each dollar they give to charity or pay in mortgage interest. Obama's budget proposal, which is currently wending through Congress, would lower the value of the deduction to 28 cents per dollar donated. 

People paying less tax rates lower than 28 percent would be unaffected.

But is it really the best way forward? Both deductions are well-established (the mortgage-interest deduction dates to 1913, the year the income tax was imposed), and many seem loath to surrender them. 

It is important to consider the deductions' goals, which seem straightforward enough: encourage homeownership and giving money to charity.

That seems simple enough, right? But as always, the devil is in the details, which are after the jump.

Let us examine the homeowner deduction first. What are its downsides? First, it distorts the market toward larger homes. The value of the benefit rises with the size of the mortgage, and in general, the larger the house, the larger the mortgage.

Also, it is regressive. The benefit is larger for those with higher incomes. Homeowners in the 35 percent tax bracket receive more than twice the savings of those in the 15 percent bracket, even if both have identical mortgage sizes.

Progressivity is a normative issue, but it is safe to say that it is embodied in the American tax system.

Obama's plan would reduce, but not eliminate the regressivity and the incentive to buy a larger house. So what else is there?

One suggestion comes from former President Bush's 2005 tax reform panel. It suggested replacing the deduction with a tax credit equal to 15% of mortgage interest paid. It also lowered the cap on the maximum deductible mortgage value, currently $1 million, to the average home price in an area.

This system would remove the regressivity altogether, and it generally eliminates incentives to buy large houses.

For more info on the problems with the mortgage-interest deduction, check out this article by Harvard economics professor Edward Glaeser.

The tax reform panel also addressed the charitable giving deduction, which is also regressive. It suggested maintaining the deduction, but only for donations that exceeded one percent of income. The idea was to encourage donations that would not happen otherwise, rather than merely subsidizing donations that would occur regardless of the tax treatment.

Their approach takes a different tack than Obama's. It is still a regressive benefit, but the regressivity is reduced. It also is more focused; after all, if people are going to donate regardless of the tax benefit to doing so, what is the sense in subsidizing it?

With either approach, however, there is a fear that charities could lose out on donations.

It is quite possible that Obama's deduction changes will be stripped out of the House and Senate versions of the budget resolution, so this discussion may be for naught.

Are Obama's proposals a good idea, or are the Bush tax panel's ideas better? Or should the deductions just be left alone? Tell us what you think.