Analysis of Specific Tax Provisions in President Obama's FY2014 Budget

ANALYSIS OF SPECIFIC TAX PROVISIONS IN PRESIDENT OBAMA’S FY2014 BUDGET Benjamin H. Harris, James Nunns, Kim Rueben, Eric Toder, and Roberton Williams Urban-Brookings Tax Policy Center May 8, 2013 ABSTRACT This document reviews several notable tax proposals in President Obama’s Fiscal Year 2014 Budget. These include a 28 percent limit on certain tax expenditures, a cap on tax preferences for retirement savers with high balances, a minimum tax (“Buffett Rule”) on high-income taxpayers, alternative incentives for infrastructure investment, and a new measure of inflation (“chained CPI”) for indexing tax parameters. 2 28 Percent Limit on the Value of Certain Tax Expenditures Tax expenditures are special deductions, exclusions, or deferrals in the tax code that lower taxes for selected activities or taxpayers. For example, taxpayers not using the standard deduction may claim itemized deductions for state and local taxes, mortgage interest, and charitable contributions, and workers compensated with employer-provided health insurance do not pay taxes on the value of the premiums. Because exclusions and deductions reduce taxable income, their effect on tax liability depends on the taxpayer’s tax bracket. For example, exclusions or deductions totaling $10,000 reduce taxes for a person in the 15 percent bracket by $1,500 (15 percent of $10,000) but cut taxes by $3,960 for a person in the 39.6 percent bracket (39.6 percent of $10,000). The rationale for tax expenditures varies by provision. Some household expenses—such as those for extraordinary medical costs or employee business expenses—arguably reduce a taxpayer’s ability to pay and should therefore be deducted in computing taxable income. Other deductions and exclusions subsidize behaviors, such as charitable giving and home purchases, which many believe generate wider social benefits. Similarly, the exclusion of interest on state and municipal bonds reduces borrowing costs for states and localities, the exclusion for employer-paid health insurance premiums encourages employers to provide health benefits to their workers, and the deduction for contributions to qualified retirement saving plans encourages workers to save for retirement. Economists often question the justifications for tax expenditures. For example, retirement security provisions may not boost overall saving much because people can contribute by shifting wealth from other accounts. The exclusion for employer health insurance may encourage excessively generous benefits and raise health care costs. Moreover, even when tax subsidies encourage desirable behavior there is rarely a good reason for providing a larger subsidy per dollar of the favored activity to higher-income than to lower-income taxpayers. The president proposes limiting the tax benefit of itemized deductions and specified exclusions and deferrals to no more than 28 percent of the amount of the exclusion or deduction, starting in 2014.1 The limitation would increase taxes for taxpayers whose marginal tax rate exceeds 28 percent and reduce the incentives that these tax preferences provide them. The administration estimates that the proposal would increase revenues by $529 billion between fiscal years 2014 and 2023.2 1 In addition to itemized deductions, the limitation would apply to exclusions of state and local bond interest and employer-sponsored insurance purchased with pre-tax dollars and deductions for health insurance costs of self-employed individuals, employee contributions to defined contribution retirement plans and individual retirement accounts, income attributable to domestic production activities, certain trade or business expenses of employees, moving expenses, contributions to health saving accounts and Archer MSAs, interest on education loans and certain higher education expenses. 2 The 28 percent limitation would apply to itemized deductions that remain after the current law limitation on itemized deductions (Pease). Under Pease, taxpayers with AGI above $250,000 ($200,000 for single returns) lose 3 cents of itemized deductions for every additional dollar of AGI above these income thresholds. This effectively amounts to an increase in marginal tax rates for high-income taxpayers who itemize, but for most of these taxpayers 3 In contrast to a similar proposal in last year’s budget, the current 28 percent limit applies to all taxpayers—instead of only those with adjusted gross income of more than $250,000 for couples and $200,000 for single filers. This change would simplify the application of the limit for taxpayers. Almost of all the increased taxes from the proposal would continue to be paid by taxpayers with incomes above those threshold amounts. The 28 percent limit would reduce, but not eliminate, incentives for high-bracket taxpayers to engage in certain behaviors, such as giving to charity or taking out a bigger mortgage. Retirement sav