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November 29, 2012

Why vague plans to limit tax breaks may soon die

As negotiations over the fiscal cliff get down to details, they will become more arduous — something that financial markets seem to be ignoring. The superficial appeal of proposals to limit tax expenditures, for example, will fade as the details become clearer.

Whether the negotiators can navigate the obstacles and still get a deal done before Dec. 31 remains an open question. Automatic tax increases and spending cuts are scheduled to take effect at the beginning of January.

On their face, proposals to raise revenue by limiting tax breaks enjoy unusual bipartisan support — at least when they are described generically as "broadening the tax base and eliminating loopholes." Enacting legislation, though, requires much more than such platitudes, and therein lies the political difficulty.

Take the recent proposal to limit itemized deductions to a maximum of $50,000 a year. According to the Tax Policy Center, that would raise more than $700 billion over the coming decade, almost as much as the marginal-rate increases the Barack Obama administration is proposing for high-income taxpayers. Because median household income is also about $50,000, that level of allowable deductions strikes most people as extraordinarily generous, adding to its luster.

Perhaps more important, the proposal doesn't specify which deductions would be limited, but rather leaves that up to the individual. It thus reflects the new fundamental law of political economy: The vaguer the proposal, the better.

Let's take a closer look at the effects of such a limit, though. In 2009, according to data from the Internal Revenue Service, taxpayers who itemized their deductions and had incomes of more than $200,000 had average deductions of $50,000 or more. For those with $200,000 to $500,000 in income, average deductions amounted to more than $51,000; from $500,000 to $1 million in income, the average was more than $100,000. At higher incomes, the averages rose further.

That households with incomes of more than $200,000 would be disproportionately affected by the deduction limit is neither surprising nor necessarily troublesome. Here comes the problem. In 2009, those taxpayers deducted more than $300 billion, 90 percent of which came from just three categories: taxes paid (mostly state and local taxes), home-mortgage interest and charitable contributions.

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