Monday, July 25, 2011

Preparing For D-Day: When Congress Takes Your Deductions

By Laura Saunders, Wall Street Journal

Some people call them "tax loopholes," while others prefer "tax breaks." In Congress, they are often called "tax expenditures."

Whichever term of art you prefer, hundreds of tax deductions, credits and exclusions that taxpayers rely on every year are at risk of being cut.

The debt-ceiling debate cast these benefits into the spotlight when Senate Finance Committee member Tom Coburn, a Republican from Oklahoma, on Monday released a budget plan he calls "Back in Black." Sen. Coburn's $9 trillion, 10-year package of debt-reducing measures includes $1 trillion in reclaimed tax breaks.

Introducing the plan, he sought to reframe the debate as one of cutting wasteful government spending rather than raising taxes. "Tax subsidies are socialism," he declared.

Of course, one taxpayer's senseless subsidy is another's worthy incentive. The low top rate on long-term gains is supposed to encourage investment. The Earned Income Tax Credit helps the working poor, and the charitable donation deduction fosters worthy causes.

Sen. Coburn's move was followed by another. The Senate's "Gang of Six"—three Democrats and three Republicans, including Sen. Coburn—called for cuts in tax breaks, along with spending cuts and lower marginal tax rates. President Obama's reaction was positive.

What matters now: These breaks aren't cheap. All told, the top 10 individual tax breaks will cost more than $3 trillion in forgone tax revenues between 2010 and 2014, according to estimates by Congress's Joint Tax Committee.

By contrast, the top 10 corporate tax breaks will cost only $350 billion over the same period. (This disparity isn't surprising: the individual income tax long has raised far more revenue than the corporate income tax; it currently brings in more than four times as much.)

What happens next is unclear. There has been talk of postponing decisions about tax breaks until next year. Experts say the Aug. 2 debt-ceiling deadline doesn't allow time to enact major new laws, and then comes the summer recess—giving advocates time to organize to fight changes tooth and nail.

On the other hand, the idea of cutting tax breaks is officially "in play." While the Gang of Six's plan doesn't give details, Sen. Coburn's does.

His plan takes aim at many small breaks for individuals and three big ones. He would limit the popular mortgage interest deduction to first homes worth $500,000 or less, while disallowing deductions for second homes and home-equity loans. He would also limit the working poor to five years of the earned-income tax credit.

Instead of allowing open-ended tax-free employer-paid health insurance, Sen. Coburn would institute a tax-free limit of $7,500 for individual premiums and $15,000 for families. He says these are higher than the current averages, and would be frozen for years and then grow slowly after that.

How to prepare? For now, "Taxpayers who rely heavily on these breaks don't need to panic—but they should pay close attention," says Clint Stretch, a tax analyst with Deloitte Tax in Washington. Changes that are enacted usually don't go as far as changes that are proposed, he adds.

Meantime, here is a rundown of the Joint Tax Committee's top 10 tax expenditures, along with their 2010-14 revenue cost. Medicare doesn't appear on the list because Parts A, B, and D are counted separately. Added together, they would be in fourth place.

Health insurance: Employer payments for health care, health insurance premiums, and long-term-care insurance premiums aren't taxed, costing $659 billion.

Mortgage interest: Homeowners may deduct mortgage interest on up to $1.1 million of debt for up to two homes, costing $484 billion for deductions on 34 million tax returns a year.

Capital gains and dividends: Long-term gains and qualified dividends are taxed at a maximum rate of 15%. Total tab: $403 billion.

Pensions: Defined-benefit pension contributions and earnings aren't taxed (although payouts are), for a total of $303 billion.

Earned-Income Tax Credit: Some 26 million low-income taxpayers a year are expected to claim $269 billion.

Donations: Charitable contributions are largely deductible, costing $241 billion for 36 million claims a year.

State taxes: Deductions for state and local income, sales and property taxes will cost $237 billion for 41 million claims a year.

401(k): Contributions and earnings aren't taxed (although payouts may be), for a total of $212 billion.

Capital gains at death: Assets held at death aren't subject to capital gains tax. Total tab: $194 billion.

Social Security benefits: The portion of Social Security and railroad retirement payments that isn't taxed comes to $173 billion from 28 million tax returns a year.

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