The Absurdity of Capping Deductions

During the Presidential campaigns and now with the approaching expiration of the Bush-era Tax Cuts simultaneous with the sequestration cuts, a revenue-raising strategy is being bounced around: capping deductions. Now, there are some very bad ways to do this such as only having a cap for households above a certain income level. (sample) But I just want to comment on the concept.

In theory, deductions are there for a reason. They subsidize some sort of an activity that the government wants more of. This is often justified in terms of correcting some positive externality. For instance, defenders of the mortgage interest deduction speak of the fact that home-owners are more committed to their communities than renters, so they make their house more beautiful, they help out at the block party, and do other good things which benefit others. The deduction is a way to incentivized home ownership so that we may get more of those benefits. In other words, the deduction is just another way the government spends money to buy stuff.

One downside of deductions is that some people would be doing the incentivized activity even without the deduction. I might buy a slightly larger house because of the mortgage interest deduction, but the majority of what I spent on the house, I would spend anyways. I might donate more to charity because I can deduce it from my taxes, but I would donate some money anyways. I might get solar panels on my house because of the tax incentives, but my 10 neighbors would have done it anyways. All of this is a significant cost. A big chunk of the cost of the tax incentive pays for activity which would have happened anyways.

But look at what happens when we add a cap. Maybe the tax incentive was going to push me towards a solar panel, but if my charitable deduction and mortgage interest already make me hit the cap, I have no tax incentives for solar panels. But much of my charitable contributions and mortgage interest payments I would have done anyways. With a cap on the deductions, a greater proportion of the cost of the deduction will go towards paying for things people would have done anyways and a lesser proportion of the cost of the deduction will go towards providing incentives. In other words, the average dollar spent on the deduction will buy the government a smaller incentive.

It’s a bad idea. Let’s not do it.

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One Response to The Absurdity of Capping Deductions

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