12/12/2012 12:35 pm ET Updated Feb 11, 2013

The Relative Transparency of Tax Rate Reform

Although tax deduction caps are likely to be enacted as part of any political compromise before the end of the year, rate changes are far more transparent and ought to be a significant component of any reform. The White House and Republican congressional leaders clearly are divided on the prospect of raising or lowering tax rates.

With split partisan control of federal political offices, it seems unlikely that any significant modification to the current rate structure is in the cards. However, there appears to be bipartisan support for limitations on deductions for high-income individuals. Although broadening the tax base by making more income subject to tax (by, e.g., limiting deductions) is a sound and effective revenue raising maneuver, the impact on individual taxpayers is obscured compared to rate changes.

It is not surprising, then, that politicians can reach compromises on deduction limitations rather than rates. The simple fact is that rate changes and their concomitant effects are too transparent for partisans to concede. Generally speaking, people understand the significance of their top marginal tax rates, but are less likely to thoroughly analyze the consequences of reduced deductions.

Indeed, the tax code includes several deduction caps that are currently dormant as a result of the Bush-era tax cuts. These provisions are scheduled to be revived in January absent legislative action and are accordingly ripe for political bargaining. However, a major drawback to modifying deductions is that such adjustments have traditionally been phased-in to prevent unfairness or taxpayer arbitrage, which increases their complexity and incomprehensibility.

The two most prominent deduction limitation provisions are Internal Revenue Code Sections 68 and 151(d)(3). In 2009, its last effective year, § 68 required single taxpayers to reduce their itemized deductions (e.g., home mortgage interest, medical expenses) once their adjusted gross income (AGI) exceeded $166,800. The limitation was gradual and reduced such deductions by 3 percent of the amount of AGI over $166,800, up to a total 80 percent reduction of all itemized deductions.

Similarly, § 151(d)(3) provided that personal exemptions (currently, a $3,800 deduction for each taxpayer and her dependents) would be scaled back once a taxpayer's AGI exceeded a threshold amount, again, $166,800 for a single individual in 2009. This reduction was two percentage points for each increment of $2,500 the taxpayer's AGI topped $166,800. Thus, if an individual's AGI was $291,800 (and thus exceeded the $166,800 threshold amount by $125,000, or 50 increments of $2,500) her personal exemptions would be reduced entirely (2 percent x 50 = 100 percent).

Both deduction limitation provisions were gradually weakened and eventually repealed as part of the Bush tax cuts. However, they will come back into full effect in 2013 absent congressional action.

The point of describing these provisions here is to demonstrate that it is indeed difficult for the average taxpayer to determine the impact of deduction phase-outs. While they provide an admirable degree of progressivity into the tax structure (i.e., those who have higher incomes get more benefit from deductions, which effectively reduce taxable income at the highest marginal rates), deduction limitations are not a very transparent way of reforming the tax code. A current proposal to cap deductions at a flat $25,000 is comparatively simple, but is not artfully tailored to address specific deductions that are viewed as particularly problematic or to anticipate probable tax-planning maneuvers.

In contrast, if an individual pays a 25 percent highest marginal tax rate, then it's easy to see that 25 cents of the next dollar she earns will go the federal coffers. If that rate goes up to 28 percent, then 28 cents will be allocated to income taxes.

This example is an oversimplification. The tax rate is obviously applied to an individual's taxable income, and deductions and exemptions determine the amount of income subject to tax. However, generally speaking, the broad impact of rate changes is far more transparent and comprehensible to average taxpayers, and for that reason, rates are a proper locus for tax reform.

The problem, of course, is that transparency in tax reform creates unhappy constituencies, namely those paying higher rates. Politicians are far more likely to be held accountable for raising tax rates than for limiting deductions, even if the ultimate tax bills are the same. This incentive to "hide the ball" in tax reform is troubling.

David Foster Wallace satirically suggested in his posthumous novel, The Pale King, that the IRS uses the complexity of the tax code as an enforcement mechanism. "[V]ery few ordinary Americans know anything about... changes that today directly affect the way citizens' tax obligations are determined and enforced. ... The real reason why US citizens were/are not aware of these conflicts, changes, and stakes is that the whole subject of tax policy and administration is dull. Massively, spectacularly dull."

Perhaps Wallace was unintentionally accurate. Congress's ability to compromise on less transparent tax reform, but not tax rates, suggests that maybe taxpayers aren't intended to understand the consequences of such reform.