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Need Revenue? Drop the Tax Breaks

December 17, 2012

President Obama and Congress are looking for ways to stave off the looming “fiscal cliff,” the dreaded combination of tax hikes and spending cuts set to hit the United States next year. Democrats and Republicans have distinct ideas about how best to reduce the deficit, and many are eyeing tax loopholes and deductions.

That’s politically thorny, as some tax deductions are popular with voters. Americans get tax breaks for, among other things, giving money to charity. But an Economic Experts Panel, polled regularly by Booth’s Initiative on Global Markets, shows there’s widespread agreement for eliminating some well-known tax deductions. Economists say eliminating personal and business deductions would lead to “more efficient financing decisions.”

IGM regularly polls several dozen top economists to gauge their opinions on major public policy issues. The economists are all senior faculty at elite US research universities including Harvard, the Massachusetts Institute of Technology, Princeton, Stanford, Yale, the University of Chicago, and the University of California, Berkeley. A year ago, the IGM sent its panel a pair of questions related to tax reform.

The first question asked if eliminating deductions for non-investment personal interest rate expenses, such as mortgages, would lead individuals to make more efficient financing decisions. The second asked if reducing the deductibility of interest expenses for non-financial businesses would lead firms to make more efficient financing decisions. Both queries specified that these cuts would be accompanied by reduced tax rates that would be budget neutral and keep the burden of taxes by income group the same.

Most panelists agreed: 85 percent said that eliminating the personal deductions would create more efficiency, and 65 percent said reducing the business deductions would do the same. When the economists’ answers were weighted by confidence in their conclusions, 90 percent and 85 percent were in agreement, respectively.

Responding to the first question, Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance and Charles M. Harper Faculty Fellow, said, “There is no good reason for using the tax system to subsidize home purchases. Lower rates and a broader tax base are the way to go.”

Such skepticism was consistent with previous work on this topic by economists. Stanford’s Pete Klenow, for example, highlighted past related research, including a paper co-authored by Jesse Shapiro, professor of economics, that had found problems with the mortgage interest deduction back in 2002.

But some were cognizant of the political realities surrounding popular tax breaks. Given the weak housing market, politicians can’t suddenly drop the mortgage interest deduction, wrote Richard Thaler, Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics. He suggested it would be best to phase out that deduction “very gradually.” —Emily Lambert