Higher rates or fewer tax breaks: what's worse?

In the fiscal cliff wars, a pivotal battle is raging between Democrats demanding to raise revenue by boosting tax rates on the nation's highest earners and Republicans insisting on eliminating deductions and other tax breaks instead. Which is better for the economy? Analysts say it depends.

Economists generally agree that a simpler tax code with lower rates and fewer deductions, exemptions and credits would help the economy. With fewer tax preferences, people would be more likely to seek the best investments for their money instead of the most lucrative tax breaks. And lower rates would leave them more money to spend. Both would add oomph to the economy.

But ask whether the higher tax rates that President Barack Obama wants would hurt the economy more than curbing deductions, as Republicans assert, and the picture is less clear. While many economists say the economy theoretically would work more efficiently if the tax code provided fewer preferences, many said it would depend on which deductions lawmakers curb — a complicated exercise in a world where one person's wasteful loophole may be viewed by others as an economic lifeline.

For example, one of the biggest tax breaks is the widely popular deduction for interest on home mortgages below $1 million. Because of it, the government this year will take in $87 billion less than it would if the deduction didn't exist.

That deduction allows many to buy homes they otherwise couldn't afford and is strenuously defended by the housing industry. But critics say it does little to help lower-income people while it encourages others to go into debt for costlier homes than they need — an activity they say taxpayers should not subsidize.

"I'd definitely go for cutting deductions first, especially if I have the opportunity to make the choices about which deductions go," said Alan Auerbach, director of the Robert Burch Center for Tax Policy and Public Finance at the University of California, Berkeley.

The clash is a key part of negotiations for a deal to avert big tax increases and spending cuts due to begin in January — the fiscal cliff — unless Obama and Congress reach an accord on some other way to rein in the government's ballooning debt.

President Obama wants to raise $1.6 trillion in revenue over the next 10 years, partly by letting decade-old tax cuts on the country's highest earners expire at the end of the year.

He would continue those Bush-era tax cuts for everyone except individuals earning more than $200,000 and couples making above $250,000. The highest rates on top-paid Americans would rise from 33 per cent and 35 per cent today to 36 per cent and 39.6 per cent.

House Speaker John Boehner, R-Ohio, has offered $800 billion in new revenues to be raised by reducing or eliminating unspecified tax breaks on upper-income people.

There are more than 100 tax breaks with a cumulative price tag estimated at $1.1 trillion yearly. They range from huge breaks like the deduction for charitable contributions and the income exclusion for employer-provided health insurance to obscure tax incentives for capturing carbon dioxide emissions or maintaining railroad tracks.

The nonpartisan Congressional Budget Office said in a report last month that raising tax rates would dampen people's incentive to work and reduce the nation's labour supply. Raising the same amount of revenue by eliminating tax breaks would probably be less negative, but the impact would depend on which deductions were erased, the budget office said.

A separate study by the same agency and in the same month, however, suggested that the economic harm from letting tax rates rise for top earners would be relatively negligible.

That report estimated that extending the George W. Bush-era tax breaks for everyone would mean the economy would grow by 1.4 per cent more than if all the tax cuts are allowed to expire. Extending the tax breaks for all but the top earners as Obama wants would produce economic growth of 1.3 per cent, just 0.1 per cent less. In a nearly $16 trillion economy, that one-tenth of 1 per cent equals $16 billion.

While higher tax rates can discourage investment, "whether or not we actually see significant changes in behaviour from small changes in tax rates is another story," said Joe Rosenberg, research associate at the bipartisan Tax Policy Center, which analyses tax policy. "We do see some, but the magnitude is probably fairly small."

Part of the dispute is grounded in politics. Obama made raising rates on the wealthy a keystone of his re-election campaign. For two decades, Republicans have made opposition to higher tax rates their party's mantra. Neither side is eager to surrender.

The present faceoff is also a tactical duel ahead of an even larger war over revamping the entire tax code that could come next year. Both sides know that if tax rates on the wealthy rise now, it will be harder to push them back down later.

In addition, the battle underscores ideological differences in the two parties' constituencies.

Republicans say raising tax rates on high-income Americans discourages investments that would produce new jobs.

"Here's how Republicans think," said Kenneth Kies, a former top House GOP tax aide and now a tax lobbyist. "If I'm a risk-taker and I'm getting ready to invest $1, if I'm successful and the top rate is 35 per cent, I get to keep 65 cents."

If the top tax rate is much higher, Kies said, he would get to keep less "and my incentive to invest is significantly reduced."

For Democrats, imposing higher tax rates on people making the most money is a fair way to make them contribute to deficit reduction. They say Obama would merely return rates to levels that existed under President Bill Clinton, and the economy prospered then.

Because various tax breaks have such powerful defenders — for example, charities, churches and colleges — it's politically difficult to limit them. The subsequent search for revenue could expose the middle class to higher taxes, Democrats say.

During the presidential campaign, Republican nominee Mitt Romney suggested limiting itemized deductions to a dollar cap, such as $25,000. The nonpartisan Tax Policy Center estimates that capping deductions at $25,000 would raise $1.3 trillion. But 29 per cent of it would come from those earning under $200,000, whose taxes both parties say they don't want to increase.