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Tax Code Has Upside-Down Rewards for Good Behavior

Author: Peter R. Orszag, Adjunct Senior Fellow
September 6, 2011
Bloomberg.com

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As the supercommittee created by Congress to cut $1.5 trillion from the federal deficit over the coming decade begins its work, one thing that is said to be on the agenda is tax reform.

Given the complexities involved in a broad-scale overhaul of the tax system, don't hold your breath that we'll see anything comprehensive enacted this year.

If the committee wants to bring about constructive tax reform that is a bit less ambitious, however, here's an idea: Change the tax breaks that are meant to encourage people to do good things -- such as save for retirement, buy real estate, get health insurance or give to charity -- into flat-rate credits that aren't affected by the taxpayer's income. After all, it makes no sense, in terms of economic efficiency or simple fairness, to have the size of such incentives depend on earnings.

Consider the current deductions for retirement saving. If a person with a high income contributes $1 to his 401(k) plan, he saves 35 cents in income taxes. The contribution is excluded from his taxable income, so his tax is reduced by the amount of the contribution multiplied by the marginal tax rate. And, this year, 35 percent is the marginal rate on taxable incomes of more than $379,150.

A middle-income person contributing the same amount to a 401(k) would save only 15 cents in income taxes. So the system provides a smaller incentive for the middle-income person to save for retirement.

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