Don't Mess With Taxes

No, that headline question is not a spin-off of the popular television game show.

It's the question being asked as federal lawmakers struggle to come up with a fiscal agreement that will lead to another increase in the U.S. debt ceiling.

Back in March, an NBC-Wall Street Journal poll found 81 percent of those surveyed favored a surtax on millionaires to help cut the deficit. Perhaps that was part of the reason that Vermont Sen. Bernie Sanders, an Independent, introduced a bill to impose a surtax on millionaires.

Majority Leader Harry Reid (D-Nev.) took the millionaires' tax a step further, getting enough votes last week from his Senate colleagues, some Republicans included, to take it to a full floor vote on Monday.

Reid's proposal is purely symbolic, a nonbinding "sense of the Senate" resolution that says those making $1 million or more each year should "make a more meaningful contribution to the deficit-reduction effort." 

But such show appears to be all that Congress is equipped to deal with. Senate Democrats reportedly have dropped a 3 percent surtax on millionaires from the official Budget Committee proposal.

More than one way to tax a cat: While a direct tax on wealthier individuals doesn't stand a real chance on Capitol Hill, lawmakers are exploring other ways to get additional money from richer taxpayers.

Obama reiterated his intention to collect more from the country's wealthy in last week's White House Twitter Town Hall: 

It does mean that those who are in the top 1-2 percent, who have seen their incomes go up much more quickly than anybody else, pays a little bit more in order to make sure that we can make the basic investments that grow this country -- that's not an unreasonable position to take.

As for how to get that money, Obama has repeatedly championed a limit on the amount of itemized tax deductions that higher-income workers can claim.

Promoting tax Pease: This is not a new tax, although that doesn't matter to the GOP.

Before the Bush tax cuts, wealthier taxpayers had to deal with the personal exemption phaseout, or PEP, and the similar Pease phaseout, named after former Rep. Donald Pease (D-Ohio) who pushed for the law in 1990, which limited the amount of itemized deductions high-earners could claim.

PEP and Pease rules were themselves phased out completely in 2010. The extenders agreement passed at the end of last year keeps them off the books through 2012.

But Obama and many of his Democratic colleagues would like to at least bring back the Pease limits. The prez has suggested doing so in each of his fiscal budget proposals.

Essentially, this limitation reduces the tax benefit of popular deductions for mortgage inter­est, charitable gifts and state-local sales or income taxes, as well as for the lesser claimed write-offs for unreimbursed business expenses, tax preparation fees and safety deposit box expenses under the miscellaneous deduction category.

Hawaii goes first: While we all wait to see if the deduction limitation will make it into any budget or debt ceiling plan, the president's home state of Hawaii has decided its native son has the right deduction idea.

Last month, the Aloha State became the first state to cap the itemized deductions that its wealthier taxpayers can claim.

The new law is in effect for the 2011 through 2015 tax years and limits single taxpayers with adjusted gross income of more than $100,000 to $25,000 in deductions and couples with AGI exceeding $200,000 to deductions of $50,000.

While the move should boost Hawaii's bottom line, it will cost its wealthier taxpayers not only money, but tax prep time. Janet Novack of Forbes notes:

Moreover, the new law requires these folks to figure their tax bills another way, applying a federal partial phaseout of itemized deductions for the better off (U.S. Tax Code Section 68) that has itself been at least temporarily phased out by the George W. Bush tax cuts.  High income Hawaii residents must then use whichever restriction produces the higher tax bill.

Federal effect on state finances: If Congress does reinstate the limit on deductions for wealthier taxpayers, it could affect a lot of state finances.

Many states piggy-back their definitions of taxable income on the federal tax code, so a cap on deductions would increase the state income tax base for them, writes Girard Miller, the Public Money columnist for GOVERNING magazine and a senior strategist at the PFM Group. That would actually produce more state income tax revenue than an increase in federal tax rates.

Also, says Miller, the way Congress caps itemized deductions could impact state and local tax policies and local politics:

To see how this works, let's suppose that Congress decided next year to put a cap on itemized deductions of all kinds, maybe at the level of $100,000. Affluent taxpayers in some states often deduct this much for their state income taxes, local property taxes and mortgage interest. If federal tax policy limits their deductions to a fixed number or a percentage of income, then states with high income tax rates and local governments with high property tax rates would face increased voter resistance from high-income taxpayers who could no longer deduct some of these taxes on their federal returns. The net tax cost of "excessive" state and local taxes would then increase by 35 percent for those taxpayers.

So while you, I and rich folks across the country are watching with great interest what Washington, D.C., will do about the deficit, so too are state tax departments and the legislators who write the laws they enforce.

Related posts:

• What's wrong with the Democrats when it comes to budget negotiations?
• GOP needs to learn how to declare victory
• The closure of Minnesota, America's fiscal future in miniature?
• Tax cutting on Capitol Hill gets personal

Want to tell your friends about this blog post? Check out the buttons -- Tweet, Reblog, Like, Digg This and more -- at the bottom of this post. Or you can use the Share This icon to spread the word via email and other popular online avenues. Thanks!