Separating Hyperplanes

How to Cap Deductions Correctly

Matthew Martin 1/15/2013 04:00:00 PM

I often hear the argument made these days that we should limit tax deductions for the rich. There are right ways and wrong ways to do this. The right way to do it is to simply place an upper limit on the total amount that people can deduct from their taxes or taxable income. So if the maximum deduction is, say, \$25,000, then someone earning \$500,000 per year would have to pay the income tax on somewhere between \$500,000 and \$375,000 worth of income. If you make \$25,000 a year, then it is possible you could end up paying no income tax at all, if you are eligible for the full amount of deductions. Hence, this change is progressive, and ultimately generates revenue without distorting the incentive to work relative to current tax policy.

Here is the wrong way to limit deductions: Pass a law declaring that people who make over, say, \$500,000 per year cannot claim any deductions. This is wrong because it violates the most fundamental rule for any tax code: increasing your pre-tax income should always, always increase your after-tax income. But this reform proposal violates this rule. To see how, just suppose that you are making \$499,999 per year and claiming \$10,000 in deductions. Your boss offers you a \$1 raise. Now you make \$500,000 per year and can claim \$0 in deductions. With a top marginal tax rate of 39.6%, that means that a \$1 raise actually made you \$9,999.60 poorer.

The Arthurian 1/20/2013 05:35:00 AM

Hi Matthew. Came here from Macromania because I thought your comment was really interesting.

I have a somewhat similar idea to yours here:
Replace all existing deductions with one high standard deduction -- higher than the poverty level. Replace the existing tax code with a single rate. Such a tax would be progressive (as yours is).

I would also put a 100% tax on income above some very high level, because if there is no limit to income, there is no limit to inflation. This is exactly opposite to your approach. But what's the sense of making more money if it's just inflating away?

Mine creates a window in which the distribution of income can freely move, and protects the dollar.

Art

Matthew Martin 1/24/2013 08:48:00 PM

I have heard similar ideas before. I think it would be very difficult (maybe infeasible) to achieve the same degree of progressivity with the flat tax+refundable deduction (it would be even less progressive if the deduction is non-refundable). I studied the Mirrlees optimal taxation research, which shows that (if you put any faith in the welfare predictions of economics) your policy is still somewhat sub-optimal. The optimal tax code has a large amount of redistribution from the rich to the poor, which produces high marginal tax rates for the rich (we take increasing shares of their income as they earn more) and for the poor (we reduce their welfare benefits as they earn more, with low marginal tax rates on the middle of the income distribution.

Also, many papers in the Mirrlees literature suggest, similar to what you say, that the marginal tax rate should converge to 100% as income approaches infinity--I think this asymptotic limit would be better than jumping to 100% at a specific high income level.

The Arthurian 1/25/2013 05:55:00 AM

Thanks Matthew. I looked up Mirrlees and found "Tax by Design" which is exactly the right approach. "This is not a book about how much public spending or how much redistribution there should be. Nor are we addressing the question of what is the right total level of taxation."

Far more important than "how much" is "how" to tax. Very nice. I shall have to do some reading.

But let me point out that "as income approaches infinity" the dollar's value approaches zero... In practice, "ceteris paribus" doesn't hold.